The onslaught of “security obligations”.

Testimonials from savers disillusioned with their so-called “supercautious” portfolios are legion these days.

Among them is this misadventure reported by a portfolio manager, the story of a household who sold their house last fall and put the money into a seemingly risk-free fund.

That nest egg would have shrunk by a few tens of thousands of dollars, which is a bad start to buying a new home.

In question: the rush of bonds that are considered safe. I told you about it the other day. Now the question: Can this ordeal last much longer?

Bond Basics

We don’t often talk about commitments. After a few decades without too much disruption, we were convinced that bonds were rock solid.

We also have to say that in normal times they are not the most exciting chronicles. It’s more interesting to tell the troubles of publicly traded companies (and their stocks and their leaders) than to tell the linear journey of a Canadian bond…

This stability has been broken since the beginning of the year. The broadest FTSE TMX Canada Universe Bond Index is down more than 10% since December 31st. The bond market hasn’t been this battered since the 1980s.

I’ve mentioned it two or three times without explaining it, bond values ​​move in the opposite direction of interest rates. Here’s the mechanics (it’s mechanical), illustrated by a quick example of a $100 bond paying 2% interest per year, so $2.

Let’s say I want to sell it before maturity to get my principal back. Let’s say interest rates have increased between the time I bought my bond and the time I want to get rid of it. The investor I want to sell it to now has access to new bonds that are yielding 3%, while mine is only yielding 2%. In order for this investor to consider my offer, it must offer them at least 3%. I would therefore have to lower my bond to $66.67 for it to deliver that yield ($66.67 x 3% = $2). The value of my bond has theoretically lost a third of its value.

I’m simplifying, but that’s the principle.

Note that the converse is also true. When interest rates fall, bond prices rise. This is what happened at the beginning of the pandemic. Many bonds seem to struggle if they just deflate.

What is happening in the fund?

Will you let go of a 33% down bond and crystallize your loss? Probably not. You keep it until the due date to get all your money back.

It’s the same for a fund, except that it must reflect the price fluctuations of the bonds it contains in the price of its shares. Hence the decline in the value of portfolios on paper. As long as you don’t need your capital, it’s not a serious problem, but it’s frustrating when these falls occur when you need to withdraw, as they do for retirees who believed in bond security.

Confused, but until when?

That still doesn’t answer the original question: How much longer can this go on. You can imagine the otherwise flatter answer: it depends.

Everything is based on the development of bond rates, which are not directly linked to central bank decisions. In an environment of high inflation, buyers of securities who act as lenders (to countries and companies that issue the bonds) demand more generous interest rates. For example, Canadian 10-year bond yields have risen from 1.75% to 3% year-to-date, a significant and rapid jump.

There are voices among fixed income portfolio managers who say that inflation will be brought under control sooner rather than later and that interest rates are on the verge of stabilization. The most pessimistic, on the other hand, predict an uncontrollable rise in consumer prices, leaving interest rates just beginning to rise.

In such a scenario, short-dated bonds arguably offer better protection, as anything longer than five years could suffer a bit. The average maturity of the FTSE TMX Canada Universe Bond Index is over 10 years. As for high quality “bond” funds, I don’t know.

We close with a glimmer of hope. In an environment of higher interest rates, fewer assets are needed to generate the same returns. Retirees can ultimately benefit, but at the expense of a nerve-wracking crossing.

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