Rising rates

In the US, the Federal Reserve hiked interest rates by 0.75% in both July and September, bringing the federal fund rate to 3.08%. “Reducing inflation is likely to require a sustained period of below trend growth,” said Federal Reserve Chair Jerome Powell in his August press conference. “Moreover, there will very likely be some softening of labour market conditions.”

In Canada, the Bank of Canada raised the target for its overnight rate by 1% in July and 0.75% in September. These hikes brought the key interest rate to 3.25%. Globally, further interest rate increases are needed in most major economies to anchor inflation expectations and ensure inflation pressures are reduced.

Sometimes bad news is good news, at least it has seemed that way lately.  For example, there was a significant decrease in the ISM Purchasing Managers Index (PMI) where new orders dropped from 51.3 in August to 47.1 in September.  A reading over 50 indicates growth or expansion while a reading below 50 suggests contraction. With the lower reading, it could be a sign that the interest rate hikes are having the desired effect of reducing inflation. 

Credit spreads (the difference in yield between a corporate and government bond with the same maturity)  are slowly widening, but still relatively narrow compared to this year's high, and well below the 2020 pandemic highs. Bond credit spreads are often a barometer of economic health where widening is bad and narrowing is good.   Lower credit spreads can also indicate that issuing companies are still in good condition to repay their debt obligations.

Given that this has been a very eventful year on the bond market, we are fielding more questions about how bond pricing works. The simple answer is that it comes down to math. A bond is a loan to a government or corporation. They are issued and mature at par value, and during the term of the loan interest payments (or coupon payments) are received by the investor. 

Here is an example to illustrate how interest rate changes impact the price of bonds. 

1. Let’s assume that on Oct. 1, 2021 an investor buys $1,000 of a newly issued five- year Government of Canada bond paying a 1% coupon. That investor receives the bond and going forward they will receive a $10 coupon payment each year. At maturity in five years, the investor would receive their $1,000 back plus one more coupon payment of $10. The end result is that the investor received $50 of interest. 

2. Let’s move ahead one year to Oct. 1, 2022. The investor has received their first coupon payment of $10, and now has four payments left ($40 total) and will still receive $1,000 at maturity.

Let’s also say that interest rates have gone up and a newly issued four-year government bond is now paying a 2% coupon. The newly issued bond would look like this:

If the investor now wants to sell the bond they purchased one year earlier, it would not look that attractive to a potential buyer. The potential buyer could buy a new bond with $80 of interest, so why would they buy the investor’s bond with only $40 of interest payments left? 

3. In order to sell the bond, it would need to be priced so that the potential buyer would still make $80 if held to maturity. That means the bond would need to be sold for $960. The new buyer would receive the $40 in coupon payments and would see the price appreciate by $40 as the bond would still pay out $1,000 at maturity.

In this example, an interest rate increase of 1% resulted in the bond price dropping by 4% ($40). The key to remember here is that even though the price of the bond has dropped by 4%, this is not a permanent loss as the bond price has to appreciate back to $1,000 by the time the bond matures. From Oct. 1, 2022 onward the future return of the bond has increased as the investor will receive the same coupon payment, with guaranteed price appreciation.

There have been a few slight adjustments to sharpen the edges of our bond strategies within the Compass Portfolios and the ATBIS Fixed Income Pool. We have been slowly increasing our weight to higher quality and highly liquid credit positions. Should business conditions worsen, and credit deteriorate, these highly liquid securities can be pivoted back into higher-yield fixed income if they present exceptional value to unitholders. In the meantime, the overall bond portfolio including mortgages as of the end of the quarter was priced to yield 5.6%.

In equities, valuations look very attractive as earnings have remained resilient while equity prices have declined. One such measure for stocks is earnings yield, which for global stocks, started the year at around 5%,¹ and is now closer to 7% as a result of prices declining close to 20%. From this lens, we have confidence that we are being adequately compensated for holding our bonds and equities right now. We also partner with sub-advisors who invest for the long term in profitable, well-managed companies. Each company is reviewed and our sub-advisors look for companies with healthy balance sheets and strong moats, and they are all stress tested for scenarios just like the one we are in now. It doesn’t mean the companies won’t drop in value, just that there is reasonable confidence these companies can weather the storm. From that point of view, seeing few changes from our sub-advisors in these turbulent markets underscores the conviction in our current holdings.