Peter McMurtry, B.Com, CFA, Financial Writer for Do-It-Yourself Investors
Monthly Investment Newsletter https://mcmurtryinvestmentreport.ca
Stronger global economies are resulting in Central Bank policies becoming more restrictive and this current trend is likely to continue. Bond guru Bill Gross recently stated that the bond market is entering a bear phase for the first time in many years.
Last year the Canadian bond universe XBB ETF had a total return of 2.6%, not bad under the circumstances. The 1-5 year Government of Canada bond ladder ETF CLF posted a negative total return of 0.4%, while the 1-5 year Canadian corporate bond ladder rose a modest 0.68%. Canadian Real Return bond rose at a 1.25% clip. Canadian Floating rate bonds had a total return of 1.41%.
In the US 10 Year Treasuries posted a total return of 2.6%, with corporate US bonds rising by 5.99%.
Complicating Canadian investors’ returns from US bonds was the fact that the US greenback fell by 6.5% versus the loonie in 2017.
While preferred shares are really equity, I am including them in my newsletter commentary as they do provide a solid income in this environment. Last year the Canadian actively run Horizons preferred ETF HPR rose at a very respectable 15.94%, with the Canadian preferred iShares CPD rising by 13.6% over the same period.
At year end the US yield curve (10 year less 2 year) spread closed at 52 basis points. It has subsequently risen in January to the current 60 basis points.
The Canadian yield curve spread was only 34 basis points at year end, but has risen to 41 basis points in January.
In my last newsletter in December I itemized the specific reasons why the current flat yield curve is not the precursor for an impending recession.
Given where we are in the economic cycle, inflationary pressures have been historically much lower than normal. However overall inflation is now expected to start rising at a faster clip. The combination of strong employment, higher commodity prices and continuing US trade protectionist policies will ultimately lead to higher inflation. The bond market does not like higher inflation as it means higher interest rates.
As the current outlook is for rising rates but in a strong economy, I continue to recommend the following:
Despite the very low interest rate spreads between investment grade corporate bonds and government ones, the additional yield pickup is worth the risk.
I do not favour high risk bonds and ETF’s with the credit risk being much higher than investment grade bonds.
I continue to like Canadian rate reset preferreds that will benefit from rising rates. Every five years these preferreds are reset and will most likely be reset to a higher rate with rising rates. However we cannot forget what happened to Canadian preferreds during the last recession when rates went down sharply. They fell dramatically in some cases more than common equities.
At some point in the future we will experience another recession that will result in lower rates. You do not want to own any rate reset preferreds in a recession.
However as long as interest rates are rising, Canadian rate reset preferreds should do well. Once again it is important to stick to quality companies to minimize the credit risk. Paying attention to call dates and call prices is also very important. The likelihood of a recent preferred issue being called at a disadvantageous price to the investor is not likely if rates continue to climb, but it is still important to check for these details. Many retail investors prefer buying an ETF to avoid having to do this extra research. Both the iShares CPD and the Horizons HPR preferred ETF are mainly rate reset preferreds.
Do not invest in individual perpetual preferreds at this time as their share price will fall sharply in a rising rate environment, comparable to long bonds.
Hank Cunningham, a well known Canadian bond manager and author, believes firmly in the following:
Investing in a 1-10 year bond ladder, instead of the traditional 1-5 year one, to pick up incremental yield
Develop a close relationship with your investment advisor to ensure that imbedded trading commissions are kept low. This assumes that you are not dealing with a discount broker and is a largely self fulfilling statement with Mr. Cunningham working for a full service broker.
However it does convey the message that the retail investor is paying higher commissions relative to the institutional investor and it is important to watch closely what purchase yield to maturity one is receiving.
Hank Cunningham does not like bond funds and ETF’s relative to individual bonds as the bonds never actually mature but are constantly traded in and out in a fund. Purchasing individual bonds at an attractive yield and holding them to maturity is his recommendation.
Personally I have worked in this business all my career and have my own ideas as to what is the best strategy for the investor.
Purchasing small quantities of individual bonds, under $500,000 for each purchase, frequently results in much lower yields as a result of liquidity issues. The bond market is a much larger securities market than the equity one and is largely dominated by institutional money managers that buy very large quantities of bonds.
One way of getting around this liquidity problem for retail investors is to buy new issues and hold them to maturity. However this is not without its own problems as any one new issue may not satisfy the investor’s specific preferences for investing in a certain maturity.
My preferred choice for investing in bonds is to purchase low fee bond ETF’s such as the 1-5 year corporate bond ETF CBO. When purchasing a bond ETF, it is important to look at the fund’s average weighted yield to maturity and not to simply look at the dividend purchase yield. Yield to maturity includes both the current yield and the gain or loss in price when the bond price reverts to par at maturity.
In regards to Canadian preferreds, I still recommend the combination of both ETF’s and individual issues. The preferred equity market is geared largely for individual investors so I am not against buying individual preferreds.