Coupled with the historically low interest rates discussed in the first instalment in this series, the resurgence of inflation over the past year may pose a legitimate threat to fixed income investors. The rise in prices of goods and services—Canada’s Consumer Price Index for November 2021 was up 4.7% from a year earlier—raises the bar for the returns needed to maintain investors’ purchasing power. Inflation also tends to drive up interest rates, which in turn increases bond yields. And when yields rise, the value of your fixed-income assets goes down.
Additionally, there are subtler risks. As we discussed in the first post in this series, today’s low interest rates tend to magnify the impact of minor rate increases, leading to higher volatility in bond prices. Further, the spike in inflation in 2021 was seen to bring greater correlation between equities and fixed income, resulting in higher portfolio volatility.
Our view is that, while these issues are real and should be diligently monitored, they are not cause for panic. First, the likelihood of multiple, successive overnight rate hikes remains low. Central banks across the developed world are motivated to do everything they can to keep rates low due to governments’, corporations’ and consumers’ high debt levels. This is especially true in Canada, where household debt represented 175% of net disposable income in 2020 (compared to 101% in the United States).
A recently uncovered memo to then-Finance Minister Bill Morneau from February 2020, before the onset of the COVID-19 pandemic, warned of the risk of large-scale insolvency should interest rates rise further. “If raising the overnight rate to only 1.75 per cent could set off a climb in insolvencies, before any major job losses have been seen, it’s clear that taking rates to anywhere near what was historically neutral, or even where some models might currently put neutral, could prove to be overkill,” CIBC economists Benjamin Tal and Avery Shenfeld wrote at the time.
Second, just as the persistence of today’s inflation spurt is a matter of debate, the linked increase in stock/bond correlation may turn out to be a passing anomaly. Since 2000, there’s been a consistent low correlation between the two asset classes. Even a very low positive correlation provides some diversification benefit to your portfolio.
Third, PIMCO senior executives noted in a secular outlook in October, the long-term factors that have suppressed inflation and interest rates for more than a decade, such as demographics, the balance of savings and investments, and debt levels, are still in place. Regardless of whether inflation remains persistently higher, the uncertainty will weigh in on fixed income assets.
To the degree that the current surge in inflation engenders higher volatility in bond prices, that can actually provide more opportunities for the managers of the Nicola Bond Fund to outperform the broad market. For example, our managers can hedge the duration (sensitivity to interest rates) of the bond portfolio, reducing losses in the event that interest rates rise. There are more moves we can employ to enhance the upside potential, which we will discuss in more detail in the third and final post.
Next: Bond outlook and strategy
This material contains the current opinions of the author and such opinions are subject to change without notice. This material is distributed for informational purposes only. Forecasts, estimates, and certain information contained herein are based upon proprietary research and should not be considered as investment advice or a recommendation of any particular security, strategy or investment product. This investment is intended for tax residents of Canada who are accredited investors. Residency restrictions apply. Please read the relevant documentation for additional details and important disclosure information, including terms of redemption and limited liquidity. All investments contain risk and may gain or lose value. Please speak to your Nicola Wealth advisor for advice based on your unique circumstances. Nicola Wealth is registered as a Portfolio Manager, Exempt Market Dealer and Investment Fund Manager with the required provincial securities commissions.