a subsidiary of Purpose Investment Inc.

A Year Later, Volatility in Bonds is Still Looming…

It was right around May 1st, 2013 that interest rates began to spike, the first real foreshadowing of the Fed taper to come.

The last year has seen our firm market a fixed income solution called the Redwood Unconstrained Bond Fund.  I’m pleased to report that over the course of the past 12 months, the fund has returned a net 5.6% to investors, putting it in very good company near the top of the fixed income returns available to Canadians.

Our message has been simple.  After 30 years of decreasing interest rates, the potential for price appreciation/capital gains in bonds is unlikely, if not impossible going forward.

Many typical bond funds and ETFs will be punished as interest rates increase.

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When I read yesterday’s article that Investors Line Up for a half century of low returns in the Globe (GoC RELEASE,) highlighting the demand for a recent 50 year Government of Canada bond issue I thought it was worth highlighting the types of investors participating in this deal.

Liability-driven investing (http://en.wikipedia.org/wiki/Liability-driven_investment_strategy) is the key reason why the likes of Ontario Teachers, Sun Life and other institutional investors participated in the 50-year bond issue.  In short, when you have long duration liabilities which are interest sensitive investments, you should attempt to guarantee cash flows to match those future liabilities, and also to hedge against inflation and various interest rate risks.

The issue for individual investors lies in the shorter-term volatility of longer-term bonds.  While pension funds with long-dated liabilities can handle interim volatility, the bond outlined in the Globe article would be incredibly volatile given a change in prevailing rates.

In fact, in a theoretical scenario where interest rates were to increase 1% on the bond’s first day of trading, investors, including some very smart institutions would experience a 21.7% decline in the price of that 50-year bond.

It would take an investor about 7.5 years of coupon payments to make back the capital lost if this hypothetical scenario were to transpire.

Our partners at Reams Asset Management continue to play significant defense, as they believe rates are likely to increase.  The fund, with a current modified duration of -3.2 years, is positioned for a rise in rates.

My colleague recently attended a conference of high profile hedge fund investors.  Paraphrasing Larry Summers, he said ‘investment trends take longer to develop; but happen much quicker than expected when they arrive.’

Last May-July is an example of that, when bond investors were burned by a sudden back up of rates.  While we are not adding a timeline to our prediction of higher rates, if another increase in rates were to occur as it did last summer, how would your portfolio fair?

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