Bond positioning as yields rise

If you haven’t already done so, it’s time to consider going short duration on bonds.

With the trend toward higher yields, “investors should remain short duration, sacrificing income to better shelter market value should yields move more than expected,” says Richardson GMP in a market report.

While the firm says it remains constructive on equities in the coming quarters, its biggest concern is the resurgence of inflationary pressure or inflation fears if economic data continue to be positive, with subsequent higher yields.

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In the longer portion of the yield curve, National Bank forecasts 10-year Canadians trading at about 2.57% by year-end and about 3.09% in December 2019; 30-years, at about 2.63% and 3.14%, respectively.

The bank’s current recommended asset allocation for fixed income is about 47% short versus the benchmark allocation of about 45%. Recommended duration is 7.22 years versus the benchmark of 7.56.

Effective bond positioning is a particularly important consideration right now for those investors who unquestioningly trust that bonds will help protect their portfolios when equities drop.

While that’s sometimes the case, the Richardson GMP report shows it isn’t a hard-and-fast rule.

The report graphs the rolling 10-year correlation of monthly Canadian equity and bond returns, which shows that correlation has been below zero for most of the last 20 years. However, it was positive in the 70s and 80s, which means that often when equity markets were falling, so too were bond markets.

Why the difference?

The past two decades have been characterized by low inflation and lower economic growth. “Deflation has tended to be a bigger fear than inflation,” says the report. In the last two decades, “most periods of equity market weakness were triggered because growth was faltering, which means yields fell and bond prices rose.”

In contrast, times of market weakness in the 70s and 80s were triggered by inflation fears, which often led to falling prices for both equity and bond markets. “Or at least bonds were not providing nearly as good a portfolio stabilizer,” says the report.

If inflation fears appear, Richardson GMP says investors should do what worked well in the 70s and 80s: look to short-term bonds and cash, as well as to commodity exposure.

Read the full reports from Richardson GMP and National Bank.

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