How to Invest in Bond Funds During Record Inflation - Nicola Wealth

How to Invest in Bond Funds During Record Inflation


It’s bad enough that nearly a fifth of the global bond market carries a negative yield. With the re-emergence of inflation over the past year, the situation for real bond returns looks even worse; they’re almost all in the red.

So why even hold bonds? While we acknowledge the challenges facing the asset class—Nicola Wealth has from its inception been a proponent of diversification beyond stocks and bonds—in this three-part series we’d like to offer some reassurance that there is still a case to be made for an allocation to bonds in your portfolio. While some of their advantages have been compromised, bonds still provide attributes not readily replaced by other assets. Moreover, with the kind of active management employed by the Nicola Bond Fund, we can make the best of a harsh climate for fixed income. For example, we take advantage of low borrowing rates and use leverage on high quality credits like bank debt to seek reasonable returns in a low return environment.

The COVID-19 pandemic initially had the effect of driving bond yields down lower than they already were as investors sought safe assets. The macroeconomic story in 2021 shifted to inflation as partial reopening of economies laid bare labour and supply shortages resulting in rising prices for a great many goods and services. So even though yields began to rise, real returns for bonds plunged.

That has left investors with two choices, neither of them palatable. They can invest in high-quality bonds and endure negative real returns or move to lower-quality securities that come with a risk of default, higher volatility and potentially greater correlation to equities, all for just a low positive real yield.

Low interest rates have also made bond prices more sensitive to interest rate changes. However, as a recent paper by RBC Global Asset Management shows, the price return is only part of the equation; the income bonds provide remains stable. Hence they continue to add some return stability to your portfolio. At the same time, bonds retain a low correlation to equities so bonds still play an important role in diversifying your portfolio.

Because North American bond yields generally remain higher than in other developed markets, they also provide some downside protection, along with liquidity.

Furthermore, active management can help make up for some of the bond market’s challenges right now. The Nicola Wealth Bond Fund focuses on high-quality corporate bonds. This derives from our strong conviction that, for example, Canada’s big six banks may bend but won’t break in the face of potential threats. (A quarter century has passed since the last failure of a Canada Deposit Insurance Corporation member, and that was the relatively small Security Home Mortgage Corporation.) We can take advantage of their higher yields than government bonds, then boost those returns by borrowing at low rates to increase our holdings and thus our income yield.

RBC’s research indicates that, in the context of low interest rates, active management’s relative contribution to total returns can grow, to as much as half the potential return as of 2021.

Next: the threat of inflation.