Bond Market Buzz
There's always an opportunity in the market somewhere, and right now it could be bonds
Hey everyone, welcome back to another edition of the 5i Research newsletter. In this post, we will show the backdrop for the historic decline in the bond market last year, where we think yields are heading, and why bonds might be setting the stage for an attractive setup.
Let’s dive in!
Bond Market Buzz
The Canadian 10-year Government bond yields declined from ~9% in the 1990s to ~1% by 2015, sparking a multi-decade long run in bond prices. A similar trajectory was seen in the US bond markets in that timeframe.
A simple framework for understanding bonds is that as bond yields increase, bond prices decrease, and vice versa. Bond yields and bond prices are known to have an inverse correlation, and bond yields are driven by central bank interest rates.
As some of us may have heard, bonds posted one of their worst years ever in 2022. Bond prices declined significantly alongside the rapid pace of interest rate hikes, and with this swift change in both rates and bond prices, we have just in the past few weeks begun to see some of the collateral damage of a high rate of change in asset prices, notably bonds.
There Is Always an Opportunity Somewhere
There is always an opportunity in the market somewhere, and right now we feel that bonds are setting the stage for an attractive setup.
Let’s look at how the Canadian 5-year and 20-year government bond yields have traded over the past 15 years against the iShares Core Canadian Long-Term Bond ETF (XLB). As a side note, while the 5-year and 20-year yields will largely trade in tandem, the XLB ETF price will respond more to the 20-year yield. We have included the 5-year yield to demonstrate that all yields will follow a similar trend.
We can see that over the past 15 years, bond yields have largely trended down, with some periods of volatility where the Bank of Canada (BoC) hiked and decreased interest rates. The recent move higher in bond yields from a low of ~0.5% for 5-year yields and ~1% for 20-year yields to their current levels of ~3% has caused a large sell-off in long-term bonds (XLB). In late 2022, we saw XLB decline as much as 24% on a year-over-year basis. To add to this, a 20%+ decline in bonds is quite atypical in the markets.
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What Goes Up, Must Come Down
Rates have risen in response to elevated inflation, but recently the BoC has paused interest rate hikes, and at its latest meeting, kept interest rates flat. Historically, a pause in interest rates is followed by a decline in interest rates in order to stimulate economic growth and restore consumer confidence. It is important to note that while bond yields move in tandem with the central bank interest rates, they also move in anticipation of where interest rates are heading.
For example, in the below graph, we have mapped out the relationship between Canadian 5-year and 20-year bond yields against the central bank interest rate. We can see that when interest rates rise (2017 and 2022), yields have already begun rising in anticipation of rate hikes. Conversely, when interest rates fall (2007 and 2020), bond yields are falling alongside rates or dropping in advance of rate declines. This creates an opportunity, in that we do not need to wait for rates to decline to benefit from bonds – bond yields will often decline in advance of rate decreases, thus bond prices will increase in advance of rate decreases.
Where Do We Go From Here?
So, where do we go with this information? We know now that bond yields are inversely correlated with bond prices, and that bond yields move in advance of changes by the Bank of Canada. We also know that the BoC has recently paused interest rates and the next move has historically been to decrease interest rates following a pause. This means that bond yields should begin moving lower soon, and bond prices can begin to increase.
Here we have analyzed how the 5-year and 20-year Canadian bond yields traded following the last time the BoC paused interest rates (2018), against the long-term bond ETF, XLB. Immediately, we see the inverse correlation at hand. Bond yields (grey and black lines) decreased over the next two years following the BoC decision to pause rates, and the long-term bond ETF, XLB, increased as much as 25% over the next two years.
We have also overlaid how the 5-year and 20-year bond yields (green and blue lines, respectively) and the XLB (red line) have traded since the BoC’s recent decision to pause interest rates. We can see a very similar movement in bond yields and prices so far, and while we do not expect this similar overlap to last forever, we do believe that the overall trend of declining yields and increasing bond prices to take hold.
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