The stock market is definitely the star of the investing world—it gets most of the attention from the media, analysts and individual investors.
That’s been especially true over the last year, thanks to a roaring bull market that’s sent the S&P TSX Composite Index up over 65% and the S&P 500 by over 75% since the COVID market crash bottomed out on March 23, 2020.
The bond market, by contrast, usually doesn’t attract a lot of mainstream attention even though it’s far larger than the stock market and plays a crucial role in both the economy and in diversified investment portfolios.
However, the bond market has been making headlines of late. Since the beginning of the year, bond prices around the world have fallen sharply and yields have spiked higher. (Yield is the rate of return investors currently earn from interest paid by bonds. Bond prices and yields move inversely.)
After hitting a low of just .45% last summer, the yield on the Government of Canada 10-year bond has more than tripled to around 1.50% currently. It’s been a similar story in the U.S. and other major markets.
The drop in bond prices (and rise in yields) reflects growing optimism about stronger economic growth as vaccination campaigns gather steam and stimulus continues to be pumped into the economy by governments and central banks. Investors are betting faster growth will cause an uptick in inflation, prompting higher interest rates.
It’s a big change from the sentiment that drove bond prices higher last year. Back then, the economy was suffering through a historic recession, central banks were cutting interest rates, and if anything, the concern was about deflation, not inflation. Bond prices rose sharply, sending yields to rock bottom levels.
As a result of those rising prices, the Canadian total bond market generated a generous 8.69% return in 2020. It’s been a very different story so far in 2021. The drop in bond prices wiped out more than half those 2020 gains in just two months.
This points to the relative riskiness of long-term term bonds, which are far more sensitive to interest rate changes than short-term bonds.
With interest rates being so low, many investors have been willing to buy long-term bonds or ones with lower credit quality because they pay higher yields. That’s in keeping with a general willingness these days to buy risky assets of all kinds, from cryptocurrencies to high-flying tech stocks to special purpose acquisition companies.
However, as we’ve seen with the reversal in bonds, capital markets can turn rapidly. It’s something Warren Buffett warned about in reference to low-quality bonds in this year’s letter to Berkshire Hathaway shareholders.
It’s important to remember the role a bond allocation should play in your portfolio. It’s there to cushion against volatility in the stock market and provide liquidity. That’s why we stick to short-term, high-quality bond funds in the portfolios we manage. Their low volatility provides the stabilizing benefits we are looking for through market cycles.
As for the recent drop in bond prices, the good news is that this short-term pain will give way to long-term gain. Bond yields have risen and that means higher expected bond returns over the longer term.