Finesse your fixed-income allocations

Persistent low interest rates may be a familiar challenge to long-term fixed-income investors, but the challenge has become even greater as central banks have cut rates and implemented bond-buying programs in response to the pandemic.

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“The problem right now is that bonds are essentially yielding not much more than cash,” said Avery Shenfeld, managing director and chief economist at CIBC Economics, in an interview.

The central banks of both Canada and the U.S. have cut rates by 150 basis points since the pandemic began. The 10-year Government of Canada bond currently yields 0.57%; the 10-year U.S. Treasury, 0.76%.

Over the next decade, a portfolio of Canadian government bonds could yield less than 1% — well below inflation, Shenfeld said.

If rates “creep up slowly,” maturing bonds may be rolled over into “somewhat” better yields, he said, but the portfolio would also experience price losses.

The underwhelming outlook has investors rethinking how much of their portfolios to allocate to low-risk assets — perhaps looking instead to riskier assets such as high-yield corporate bonds.

However, Shenfeld warned against taking on undue risk.

“We’re not through the worst yet,” he said, referring to an economy struggling with a second wave of Covid-19.

With the economy likely not returning to normal until late 2022 or early 2023, “the long run of sub-par results in some industries does expose investors to risks of corporate defaults,” Shenfeld said.

Suggestions for making the most of fixed income without taking on excessive risk were offered in a recent Franklin Templeton report.

These included incorporating professionally managed multi-asset solutions and alternative investments, as well as being “dynamic and discerning” on developed market government bond exposure.

“In a risk-off event, we could see greater capital appreciation in some bond markets that have higher starting points in yields,” such as Australia (where the 10-year government bond yields 0.76%), the U.S. and Canada, the report said.

While Franklin Templeton maintained that a balanced portfolio adapted to current conditions remains an “excellent” solution for many medium-to-longer-term investors, it outlined the potential for negative returns in the shorter term, requiring tempered investor expectations.

Shenfeld noted that, with short-term yields in North America hovering at 2% at best throughout the last business cycle, “the days in which you could earn 6% or 7% on a portfolio of bonds are probably behind us for the long term.”

As the economy recovers, he expects yields will slowly rise; however, “more broadly, low rates are here to stay,” he said.

The Franklin Templeton report noted a positive from lower-for-longer rates as central banks continue to be supportive: downside risk for bonds will be limited.

For a long-term 60/40 portfolio, modest return expectations of 4% to 5% are “probably reasonable,” so long as investors adapt their portfolios, it said.

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