Why your bond portfolio could be riskier than your stocks
“Most people have no idea of the risk they are taking in their bond portfolio.”
That was the view of Richard Usher-Jones of Canso Investment Counsel, independent specialist manager for Newport’s bond portfolios, when he met with our Investment Committee this week.
There are a couple reasons why this is so.
Rising interest rates cause bond prices to fall
One, interest rates are on the rise – which is bad for fixed income investments. When interest rates rise, bond prices fall, particularly longer-term bonds. For example, this year, the 10-year Government of Canada bond yield rose from 2.04% to 2.35%. The price on the bond fell 2.68% as a result.
Most investors haven’t adjusted their strategy for higher interest rates – in fact, some are behaving as if they can’t lose money in bonds.
Let’s look at what’s happened in the bond market recently to better explain the risks and help you determine whether your bond portfolio is exposed.
No additional return for more risk, or, more risk, less return
In 2018, we have seen two interest rate hikes from the U.S. Federal Reserve – with possibly two more to come.
As short term (i.e. 2-year) rates have gone up, longer term (i.e. 10-year) rates have not. When the gap, (or “spread” in bond manager parlance), between short-term and long-term rates narrows, it is known as a “flattening of the yield curve.” It means investors are not getting compensated for taking the additional risk of longer-term bonds.
This is called “duration risk” and is the first reason bond investors are taking on more risk than they may be aware of. Many people own a smattering of bonds, often through ETFs or mutual funds. Since the average bond duration of the index* is 7.2 years, this represents considerable duration risk.
This flattening of the yield curve has another important connotation. If it continues to happen, the yield curve can become “inverted” meaning short-term rates are higher than long-term rates. This is often a precursor to recession in the economy.
Complacency is another risk
Another way investors are taking more risk than they likely realize is in the credit quality of the bonds in their portfolios. Living in an environment of stubbornly-low yields for the past decade, many investors – and their money managers – have been so starved for yield they are willing to eke out a few extra basis points of return by owning more speculative issues of lower credit quality.
“Investors are ignoring the credit risk of those issues,” says Usher-Jones. “They haven’t looked at covenants or protections and defaults have been very low in this environment. This has created a sense of complacency.”
So, in addition to the low returns, the security investors receive has deteriorated. This all adds up to a bad deal for investors. And this in a category people traditionally think of as a “safe” investment!
What to do?
In the view of the Newport Investment Committee, the best offence is a good defense. Since bonds are generally considered a defensive asset class, investors may be surprised to know about the risk prevalent in them today. The solution is to shorten the duration, or term to maturity, in your bond portfolio. We have been ahead of the curve in shortening the average duration in our bond portfolios – which is currently under 2 years. “This makes our clients’ bond exposure “near cash”, and therefore much less risky than a typical bond portfolio or the index,” explains Steve Hafner, Newport Managing Director.
Another solution to play it safe in a bond portfolio is to increase quality (e.g. AAA/AA-rated issues) versus more speculative holdings (e.g. <BBB) – as we have also done in our portfolios over the past two years.
“In our case, we also continue to search for income alternatives to bonds,” says Hafner. “These include a carefully-curated mix of mortgages, private debt, preferred shares and income-producing real estate. We continue to believe that income-producing investments reduce risk in portfolios, and that where we take on risk we must be compensated appropriately.”
If it’s been awhile since you’ve taken a hard look at your bond portfolio, now’s the time. If you’d like a second opinion, please feel free to get in touch.
*FTSE TMX Canadian Bond Universe