In the May edition of The Informed Investor, we link to an update on the financial markets as well as to some tips on how successful investors manage their emotions amid market volatility. And we’re joined by George Brown, a Portfolio Advisor at RBC InvestEase, who shares some insights on the current bond market and the important role bonds play in investment portfolio.
Financial markets experienced a lot of volatility in the first few months of 2022 as a result of high inflation, rising interest rates, the war in Ukraine, and the ongoing pandemic. You can find more details on how these factors are currently affecting markets in RBC Global Asset Management’s latest market update.1
As we’ve described in past letters, the investments in different industry sectors, asset classes (like stocks versus bonds), and regions perform differently over time. That’s why a portfolio of broadly diversified investments helps to provide you with a smoother investment experience. When some of the investments you hold go through a period of poor performance, the overall decline in your portfolio can be softened by other investments that are faring better.
Still, even in a diversified portfolio, environments like the current one can be challenging for investors. U.S., emerging, and international stock markets have all suffered losses year to date, as have Canadian bond markets.2 Only the Canadian stock market has provided some relief, with its value having been supported by higher commodity prices.1
For some tips on how to keep a long-term perspective when it comes to your investments, we encourage you to read this article on how to manage your emotions as a successful investor.3
This month, we wanted to focus on the important role that bonds play in the diversified portfolios at RBC InvestEase. To provide us with some insight, we chatted with George Brown, a Portfolio Advisor at RBC InvestEase.
Q. Why are bonds an important part of an investment portfolio?
A. There is a traditional reason why we put bonds in a portfolio, and then there's an updated reason. Bonds are often referred to as “fixed income” as they were traditionally used in a portfolio to provide income. However, with interest rates being so low you don’t get a ton of income from buying bonds, at least if we think about their utility when interest rates were higher. But the “fixed” component has remained very important as a buffer to volatility and to help generate more consistent returns for investors.
Q. You mentioned that bonds act as a buffer to volatility, but I think we’ve seen over the past few months that bonds come with some volatility of their own. How should investors think about that?
A. Over the past few months the investment markets, and specifically the fixed income markets, have experienced a historically abnormal volatility. But there’s a reason. If we think about this time last year, investors were largely focusing on the pandemic and the ongoing supply chain issues that we were experiencing. What was not on their radar was inflation. Fast forward to the end of 2021 and we saw this sudden shift in investor focus to high inflation. That prompted a decline in bond prices, because investors also started to expect that central banks would have to raise interest rates to rein in that inflation.
Q. Why would that change in inflation expectations have such a big effect on bond prices?
A. The price of bonds is strongly influenced by both the level of interest rates and the expectations of investors regarding changes to those levels. When interest rates increase, the prices of bonds that were issued at lower interest rates decrease. This enables older bonds to compete with new bonds issued at higher interest rates and therefore offer a higher return to investors. You can read more about that dynamic in an article by RBC Global Asset Management here.4
One important point made in that article is that while decreases in bond prices may be painful, bond investors are likely to benefit from higher interest rates over the long term. That’s because the increase in interest rates allows future cash to be invested at those higher rates – whether that cash comes from a regular contribution to your account or income from your current bond holdings. Over time, that higher reinvestment rate helps to offset the value your bonds have lost.
Q. What do you think are in store for the bond markets going forward?
A. What’s important to remember is that when most professional investors determine the price they’re willing to pay for an investment – whether that’s a stock or a bond – they’re doing that based on what they expect to happen in the future. As I mentioned, this time last year, bond prices were telling us that investors weren’t expecting the level of inflation that we are currently experiencing. And that caused price volatility because investors rushed to adjust to the realization that their expectations were wrong.
This is where perspective is important. Yes, that sudden shift was bad for bond markets, but how do we analyze where we are today going forward? Right now bond market prices are signaling that investors expect interest rates to move aggressively higher to combat inflation. And that’s important because in order for bond prices to move higher, you don’t necessarily need good news on the inflation front. You just need less bad news. Last year there was a lot of good news. And so you only needed a little bad news to cause this kind of volatility.
Q. Any final words of wisdom to share with investors?
A. Successful investors are usually the ones that find and stick to an investment strategy that is right for them – their investment objectives, time horizon, and risk profile. At RBC InvestEase, these are the factors we use to determine a recommended portfolio for each of our clients. In volatile market environments like the current one, some investors may be tempted to cancel their contributions or to make a withdrawal. But we’ve seen through many historical episodes of volatility that investors who stick to their investment plan tend to fare better than those who allow themselves to be guided by recent performance. While the bond market has experienced volatility over the past few months, this asset class remains an important component of a diversified portfolio, and is well-positioned to help reduce volatility in your investments over the long-term.