It’s been a frustrating year for bond investors. It started off well but then bond prices plunged in late February. In mid-March they rebounded strongly, only to hit the skids again in May. As I write, the bond market is slightly higher than at the start of the year. As of June 23, the FTSE Canadian Universe Bond Index showed a gain of 1.6 per cent for 2023.
Short-term bonds have been the weakest-performing sector, up only 0.7 per cent for the year. Long-term bonds have the best record, with a gain of 3.34 per cent year to date. That may come as a surprise since long-term issues usually perform worst when interest rates are rising. But we’re dealing with a topsy-turvy market right now, with a prolonged inverted yield curve (short-term rates are higher than long-term ones).
The unusual situation has some investors wondering how they can profit. I received an e-mail the other day from a reader who asked for advice about moving into long-term bond ETFs or mutual funds.
“My thinking is that the Fed will continue to increase rates for the next few months but will eventually (possibly in early 2024) begin to reduce rates,” he wrote. “My understanding is that when this starts, there will be potential for capital appreciation in bonds.
“Could you offer your expertise regarding my thinking and, if accurate, could you identify the type of bond funds/ETFs that would be useful investments?”
For starters, the theory is broadly correct. Interest rate cuts by central banks tend to reduce bond yields, raising prices (and the potential for capital gains) in the process. Longer-term bonds normally perform best in this situation but with an inverted yield curve we could see higher gains than normal in the short-term sector.
The easiest way to invest in long-term bonds is, as our reader suggests, a mutual fund or ETF. One example is the iShares Core Canadian Long Term Bond Index ETF (XLB-T), which was showing a year-to-date gain of 2.01 per cent as of June 23.
This fund has not been a great performer recently. It lost 21.9 per cent last year, but of course that was in the midst of aggressive interest rate tightening by the Federal Reserve Board and the Bank of Canada. The fund posted double-digit gains in both 2019 and 2020, when central banks were lowering their targets.
The ETF was started in late 2006 and has generated an average annual compound rate of return of 3.83 per cent since inception. That’s not very impressive, so I would not recommend this fund as a long-term hold. But it’s an opportunistic way to play the expected turnaround in rates over the next year or so.
A far riskier, but potentially more rewarding, way to place a bet on falling interest rates (I call it a bet with good reason) is to invest in a portfolio of long-term strip bonds. I made big profits that way, back in the days when I was young and, I admit, foolish.
This was the early 1980s, when interest rates had been pushed to ridiculous highs (home mortgages were about 20 per cent) as the central banks used their heaviest artillery against runaway inflation. ETFs didn’t exist at that time and no mutual funds invested in strip bonds, so I worked with my broker to build a portfolio of my own. If I had been wrong and hyperinflation had set in, I could have lost everything (hence the foolish part). Fortunately, rates started to come down soon after and I ended up with huge capital gains.
Fast-forward to today. As far as I can determine, there are still no long-term stripped ETFs in Canada (CI has a short-term one). But anyone who wants to take a position that would benefit from a prolonged rate decline (think deep recession) might want to look at the iShares 25+ Year Treasury STRIPS Bond ETF. It trades on the CBOE BZX exchange under the symbol GOVZ.
Let me stress from the outset that this is a high-risk fund with little history. It was launched in September, 2020, and last year lost over 41 per cent as interest rates soared. As the name indicates, the fund invests in a portfolio of long-term Treasury bond strips. (Stripped bonds have had their interest coupons separated. In this case, you’re buying the principal strips.)
This is a highly leveraged way to play interest rate movements. If you buy now, expect to lose some money initially as both the Fed and the BoC have indicated more rate hikes are coming. Waiting a few months might improve your odds, although market timing is always a challenge. The payoff will come when rates turn back down – but no one can predict when that will happen.
At this point in my life, this is not a gamble I would take. But I put it out there for those who have a little spare cash and want to take a flyer. XLB is less adventurous – but still a risk.
Gordon Pape is Editor and Publisher of the Internet Wealth Builder and Income Investor newsletters.
Be smart with your money. Get the latest investing insights delivered right to your inbox three times a week, with the Globe Investor newsletter. Sign up today.
Gordon Pape