Big Change in Bond Yields
On January 1st, the Canadian government 10-year bond had a yield of 1.43%. By the end of October, the yield on that very same bond had more than doubled to 3.25%. Small change but a big deal in the bond world. So, why did this happen and what does this mean for investors and their portfolios?
The ‘why’, to put it simply, was the central bankers’ tightening monetary policy in an effort to subdue higher than expected inflation, by increasing short term interest rates. In anticipation, yields moved higher across the yield curve as investors shifted their expected required return for fixed income assets.
For investors, the surge in yields represents a return to an income investing landscape that has been somewhat lacking since the 2008 global financial crisis (GFC). As with the Covid-19 crisis, you will recall central banks responded swiftly and aggressively dropping short term rates to restore calm within financial markets. While it (arguably) achieved the desired effect of stabilizing markets, another outcome was more than a decade of extremely low interest rates and bonds yields. In fact, this recent move higher of the Canadian Government 10-year bond is the first time in over ten years that its yield surpassed the 3.0% level.
Do higher bond yields represent an opportunity for investors?
Like that of the Canadian government 10-year bond, the broader fixed income market conveyed through the FTSE Canada All Corporate Bond Index has also more than doubled to a yield of 5.2%, up from 2.3% the year prior. Naturally, investors will be more than willing to accept more than twice the yield on the same set of assets (read: higher return for little to no additional risk).
However, since assets tend to be incorporated into a diversified portfolio, it is important to consider the recent move in bonds in a relative context or compared to expected returns of other asset types. Looking at equities specifically, the S&P/TSX 60 (market weighted) Index had a dividend yield of about 3.0% over the past year. Naturally, equities also offer the possibility of capital appreciation in addition to a dividend yield, which when combined gives them a potentially greater return than the bond index. But that is what also makes them more volatile (read: riskier). With the Canadian corporate bond market offering a higher yield, investors should reconsider if the potential additional return offered by equities is indeed worth the higher risks.
Prior to 2022, a decade of strong equity markets coupled with low bond yields, gave investors few options but to embrace stocks as the way to meet their financial objectives. However, the effective doubling of bond yields has allowed investors to reevaluate their investment options. Coupled with lower historical volatility relative to equities, fixed income has begun to look more ‘interesting’ to investors looking to earn steady income with (potentially) lower volatility, and this should be viewed as an ‘increasingly competitive’ option when compared to equities.