The current weighted average return to maturity for the FTSE Canada Universe Bond Index is about 1.72%. According to Morningstar’s 2019 Global Investor Experience Study, the asset-weighted median expense ratio for Canadian fixed income funds for investors receiving commission-based advice was approximately 1.49%. For investors in paid accounts it was 0.85% plus management fees (often a further 1%).
The result is that many fixed income investors pay fees that are comparable to the expected return on an investment-grade bond, which basically does not imply a net return after fees (let alone after taxes and inflation).
Interestingly, the above-mentioned bond index achieved a return of 8.68% in 2020 – and neither many members of the investment community, nor bond investors themselves, had expected near double-digit bond returns over the past year. What was the reason for this surprise? Bonds and interest rates are moving in opposite directions, and interest rates have fallen due to the pandemic.
Similarly, bonds rose in 2020 as interest rates fell. When interest rates go up, bonds will go down. The Bank of Canada announced an interest rate announcement on April 21 and kept rates stable as expected. However, they have accelerated their inflation schedule and are returning to their 2% target by the second half of 2022, which means rate hikes could happen as early as next year if growth warms up further.
When interest rates rise, bonds fall. If interest rates rose 1%, Canadian bonds – as measured by the FTSE Canada Universe Bond Index – would fall about 8%.
What can a bond investor do? Paying 1% to 2% to earn 1% to 2% while taking interest rate risk is an opportunity. Guaranteed investment certificates (GICs) from credit unions or trusts can produce higher returns for truly conservative fixed income investors. Bonds with higher yields and lower credit ratings with higher coupon payments and shorter maturities can achieve better returns in an environment of rising interest rates.
There are alternative investments such as real estate and infrastructure, but these tend to have higher fees, poor liquidity and may be difficult to access for retail investors. These are all riskier investments than investment grade bonds and may not offer the same benefits.
Bonds are not just for return. They are also intended to reduce volatility as stocks rise and fall. Therefore, for a conservative or moderate risk investor, they should not be excluded from a portfolio just because interest rates are low.