2022 has been quite the year for investors, who have now seen geopolitical conflicts, persistent inflation and negative performance in both bond and equity markets — all in a short few months. The situation likely feels even worse given the relatively smooth stock market over the last decade. Most investors agree bonds are useful in a portfolio to add stability and reduce volatility over the long term. So what should investors do when bonds and equities are both negative? 

It's important to remember that the lower price of bonds this year can almost entirely be attributed to rising interest rates, and not to defaults or permanent impairment. Despite recent performance, we still think bonds are an important part of a balanced portfolio. Here we review the differences between holding a GIC vs. a bond and the bond positioning within the Compass^TM Portfolios and the ATBIS Fixed Income Pool.

Why bonds move down in value when interest rates rise

Let’s say rather than investing in bonds, you invest in GICs. For example, you bought a five-year GIC at the end of 2020 for $100 at 1.2% (actual rate) with maturity at the end of 2025. Rates were low, but it’s the best rate you could get at the time. Over the five years, the amount in your account stays at $100, and you collect your 1.2% interest at the end of each year. In 2025, you are paid back your final 1.2% interest payment and original $100 principal value. 

The above example is what we typically would see with a GIC investment; it is held to maturity so regardless of changes in interest rates, the value of the GIC stays the same. This contrasts with bonds that are traded daily and impacted by interest rates changes. 

Now instead of a GIC, let’s assume you bought a bond for $100 with the same 1.2% interest rate at the end of 2020 maturing at the end of 2025. In looking at your account today, you might be surprised to see the price of the bond has fallen to $92.50. Should you sell today and invest in cash-like products paying around 1%, or maybe a 3.5-year GIC paying 3.3%? In reality, the price is only lower because the forward expected return to 2025 is now 3.3% for the bond. The bond only moved down in value temporarily because interest rates moved up, and is now earning today’s higher 3.3% interest rate. Unlike a GIC, most bonds can be bought and sold on a daily basis. This is why the price fluctuates with rising and falling interest rates. The value of a bond will always adjust to reflect a comparable rate of return based on the interest rates of the day.

Had the bond in the example been a 10-year rate rather than a five-year rate, the price today would have been around $83.75 rather than $92.50, since it would have to compensate a new investor for an extra 2.2% per year over 8.5 years rather than just the 3.5 years. So longer-term bonds are more sensitive to interest rate changes than shorter-term bonds. This works in reverse too; should rates decline today, the bond value will increase since any new investor will have to compensate you for having to reinvest your sale proceeds at a lower interest rate. 

So while we are seeing negative returns right now in bonds, in reviewing the above examples, we know that the forward performance of these bonds will now be greater. Any losses taken from rising interest rates can be recouped by maturity. 

How does this translate to a bond fund or mutual fund? 

It’s the same example, but across hundreds or even thousands of bonds. Declines in price for the fund as a whole may be opaque with so many underlying holdings, but the fundamental driver of that downward performance this year has simply been due to higher interest rates. Rates have moved up close to 1.7% year-to-date for the average bond in Canada, so bond values have declined—reflecting the new lower price needed to increase the yield from now until each bond’s maturity. If held to maturity though, these losses are temporary as the bonds will still pay back the full principal at maturity and interest in the interim.

Within the Compass Portfolios, and ATBIS Fixed Income pool (the funds) in particular, the average bond held is roughly five years in maturity. To compensate a new investor for 1.7% of additional yield now compared to the end of 2021, the price needs to adjust lower by roughly 1.7% for each year, or 5 x 1.7%, giving us an expected price decline of about 8.5%. The bonds within the funds have paid coupon interest since the start of the year though buffering the downside slightly, so the decline has been closer to 7.6%.

The funds today have slid in price, but to reiterate, this has not been due to permanent loss from defaults, or other issues with payment of interest or principal. An investor has taken short-term losses as the bonds in the portfolio repriced from yielding 3% up to 4.5%. The declines experienced year-to-date however are likely to be recouped in the form of additional yield in the subsequent years. The investor expecting 3% will instead get maybe -5% in the year after investment, but with a higher yield, could average closer to 5% for the next four years. On average, the investor still earns 3% per year, just not in a straight line. 

In the following chart, you can see that the relationship between an investor's starting yield in an index of Canadian bonds composed of hundreds of bonds, and the resulting performance over the subsequent 10 years, is quite close. In March 2012, you could have bought this index with a yield of 2.47% (light blue line). Fast forward to today, when it turns out the average annual return over the past 10 years—including the lower prices this year—has been an annualized 2.54% (where the yellow line ends). This is nearly exactly as forecasted by the starting yield.