As low inflation and decreased GDP continue to be global concerns, there is much speculation over the future of the bond market. Currently, in some economies, bonds are yielding less than 0 per cent as a result of Europe and Asia’s sluggish economic growth. This raises an alarm for investors to expect a long period of deflation or decreased growth. There is also an increased possibility of some countries having to bring in further measures like quantitative easing to keep their economy running. With yields so low, what is keeping investors in bonds? And what should Canadians brace for?
Safety Driving Investors to Bonds
Regardless of monetary policy uncertainty, bonds are still considered a safe investment. With market volatility continuing to plague markets around the world, investors want to know their money is safe and are willing to take no to little return in order to guarantee their principal. Recent data compiled by Bloomberg reveals the appetite for safe assets is so strong in Europe that about 30 per cent of the $6.3 trillion of sovereign bonds in the euro area have negative yields.
Europe Continues to Drag
While the United States and, in some cases, Canada are starting to see some economic bright spots, the situation in Europe continues to get worse. Last month consumer prices were flat across all European nations that share the Euro. In Europe’s strongest economy, Germany, exports in August fell the most since the 2009 recession. As well, factory orders and industrial production also unexpectedly declined. This indicates even Europe’s strongest economies are feeling the pressure from weaker EU nations.
Liquidity Concerns in Europe
If attempts are made to unwind quantitative easing – such as raising interest rates and ending government bond buying programs – instead of ramping it up, there is concern it would dry up liquidity in the bond market and threaten financial instability across Europe. For example, in an open letter to Bank of England Governor Mark Carney, Chairman of the Treasury Committee Andrew Tyrie sets out several risks that are currently undermining the bond market. According to Tyrie, “…as the economy continues to grow, it is likely that bond yields will rise and bond prices will fall. Liquidity is likely to decline in a falling market. Market makers will be reluctant to bid until they have some confidence that the bottom has been reached. As a consequence, there may be large and sudden jumps in prices and yields.”
Next Up: The U.S. Federal Reserve
All eyes are on the U.S. Federal Reserve and whether they will raise rates by the end of the year. By all accounts it doesn’t seem that North American bond investors are panicking. It also seems markets are betting on a rate hike for the first time since 2006. The yield on the benchmark 10-year Treasury note on Friday traded at 2.280 per cent, near the highest level since July. Expectation is the U.S. is the 10-year note is likely to trade between 2.25 per cent and 2.5 per cent until the end of 2015.
Canadian Bond Investors
It’s important to understand the inverse relationship that bonds have with interest rates. As interest rates rise, the value of bonds previously purchased start to fall. They yield less compared to new bonds offered today. This prompts investors to sell their bonds, to avoid taking a loss on their investments. This leads to rising yields, and increases the costs for lenders who offer fixed loans, such as mortgage. This is why rising bond yields translate to higher fixed mortgage rates.
Bonds are issued by companies and governments seeking to raise money. They include a promise to repay the principal at a future date as well as regular interest payments until then. For example when interest first started to fall 7-8 years ago, bonds issued prior to then become more attractive. As they were yielding higher rates than the current bond with the same terms. So what should Canadians investors do? Having a well-diversified portfolio includes having a portion in bonds, or fixed income products. If you are not actively trading then having some exposure to bonds can be a smart move. Talk to you financial advisor how big much of your portfolio bonds should make up.