The initial timing and pace of this monetary policy normalization came as
somewhat of a surprise to a market that believed the BoC would postpone
action while waiting to see what the U.S. Federal Reserve would do with its
policy rate and with the long-anticipated unwinding of its balance sheet
and monetary stimulus.
As you may be surprised to learn, our outlook is not one of doom and gloom
for investors and the bond market. Here are five reasons why:
1. A tightening of monetary policy often reflects a healthier economy
The three rate hikes we have seen over the past few months reflect stronger
economic growth. The BoC responded by taking action on monetary policy to
reflect the normalization of economic conditions.
Ten years on from the global financial crisis, economic growth in Canada
and the U.S. is humming along with near full employment and inflation in
check. In this scenario, a natural course of action would be to remove
monetary stimulus and gradually increase policy rates from their
historically low levels, which is exactly what the BoC and Federal Reserve
2. High quality bonds play a critical role as risk dampeners in
It's important to keep the potential bond losses we could see from rising
interest rates in perspective. A bear market for fixed income is nothing
like a bear market for equities. Bond losses rarely exceed 10%, while
equities can decline by 50% or more.
3. Rising interest rates and low inflation could mean higher returns in
the long run
There is a well-known inverse relationship between a bond’s price and
interest rate movements. However, what is often overlooked is that if rates
were to rise and bond prices were to fall in the short-term, they should be
offset by higher yields over time.
As a general rule, if investors’ time horizons are longer than the maturity
of their bond portfolios, they should want rates to rise because this
should translate into higher nominal returns in the long run.
4. Bond prices reflect current interest rate expectations, so only
For investors who may be considering shortening duration in anticipation of
rising interest rates, it’s important to keep in mind that the market is
currently expecting a gradual tightening of monetary policy. This means
that bond prices are already pricing in a future path for interest rates
and inflation over their maturities. In fact, short-term interest rates
have and are expected to rise more than longer term yields, a scenario that
is commonly known as a flattening of the yield curve.
Simply put, the markets are forward-looking, and investors use their
expectations for future interest rates and inflation to determine the
current value of bonds. Therefore, it would only be in unexpected scenarios
when rates rise either faster and higher or lower and slower than expected
that there would be an opportunity to profit from a duration strategy. In
more expected scenarios, there would still be a term premium associated
with investing in longer maturity bonds.
5. Rates are unlikely to rise in all markets at the same time, creating
opportunities to diversify with greater global bond exposure
Our research has shown that global bonds can help diversify local
market-specific risk factors in bond portfolios, assuming that the currency
risk is hedged.1 In the case of interest rate risk, hedged
global bonds tend to outperform the Canadian bond market in periods of
rising interest rates due to the relatively low correlations of government
bonds' yields across markets.2
Examples of this in today's market would be the U.S. and Canada increasing
their overnight lending rates at a time when the two largest
investment-grade bond markets outside North America, the euro area and
Japan, have not done so due to generally lower growth and inflation. This
may change if the European economy continues to perform well, but the point
remains that monetary policy will ultimately reflect economic conditions
that vary by country and each particular market over time.
Maintaining investment discipline
As stated earlier, our outlook for the bond market is not one of doom and
gloom. In fact, the rising interest rates we have seen should be a positive
sign for long-term investors because it means the economy is improving and
returns are likely to be higher in nominal terms than if rates remained at
Therefore, we believe that investors will have their best chance of
investment success by remaining focused on their long-term goals,
diversifying their bond portfolios, keeping costs low, and remaining
disciplined through this period of monetary policy normalization.
1. Going global with bonds: Considerations for Canadian investors, Phillips, Bosse, Walker, Maciulis, Kwon (January 2014).
2. Fearful of rising interest rates? Consider a more global bond portfolio, Phillips, Thomas (November 2013).
Todd Schlanger, CFA, is a senior investment strategist in Vanguard’s Investment
Strategy Group (ISG) based in Toronto, Canada, where his
responsibilities include research on the capital markets, portfolio
construction and design, and investment market commentary.
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