A Frustrating Landscape for Private Fixed Income Investors
The fixed income market landscape in Canada continues to frustrate investors. A confluence of economic events that have taken place over the past several months has sent the 10 year Government of Canada (GoC) bond yield to as low as 1.48% as cash has funneled into the bond market. Corporate bonds have experienced a similar outcome, with high quality bond issues now offering meagre yields by historical standards (see Exhibit 1).
This environment is particularly challenging for investors who want to focus their bond portfolios on preserving capital. Because bond prices fall as rates rise, investors looking to protect their capital will often invest in laddered bond portfolios with relatively short term maturities, as shorter bonds are less sensitive to rate movements. Unfortunately, the demand for high quality bonds (government and corporate) currently far outstrips supply. As a result, when constructing a bond ladder there is very little in the way of options to invest short maturities, especially for tax paying investors.
For a private investor to earn a meaningful yield they must either buy longer maturity bonds, or consider edging down the credit scale to own lower quality bonds. For example, bond spreads for some energy sector issuers have widened by as much as 50 basis points as is evident in the following chart for Canadian Natural Resources Ltd (see Exhibit 2). However, the trade off is that either approach might contradict the investment risk constraints that have been previously set for the asset class (i.e. can hold ‘A’ or better, and less than 5 years to maturity). Instead of loosening these restrictions, a better alternative could be to hold cash and wait for a more appealing entry point.
A Case for Cash
There is a negligible spread between the 10-year GoC bond that pays 1.51% and several cash equivalent high interest savings mutual funds that pay 1.50%, and for any GoC bonds 5 years or shorter, cash actually pays more. While these savings products are susceptible to the balance sheet risk of the banks that offer them, given that the funds are liquid, an investor can be comfortable with this risk. The above figures suggest that investors would only be compensated 0.01% per year to take on the interest rate risk associated with purchasing a bond with a 10 year time horizon, and would actually be forgoing income to buy any GoC bond with 5 years to maturity or less. While corporate bonds do offer greater spreads, they are quite compressed at this time. Given these factors, holding a portion of a portfolio in cash for the time being makes sense for investors concerned with capital preservation (see Exhibit 3). It should be noted that in many cases the high interest savings funds that could be used to implement this cash strategy have limits of $5M per investor. For those still willing to buy longer and lower quality bonds, we would caution that the yield pickup may not be worth taking on the additional risk.