It was a few years ago that I suggested that “the greatest threat to stocks is bonds”. Bonds are starting to follow through with that threat, taking down the stock markets. And they have a peculiar taste for US stocks, and high flying US tech stocks in particular. It’s just more than increasing bond yields that are the threat, it’s the accompanying threat of inflation that is spooking stock and bond investors. Recently we’ve been treated to the wonderful one-two punch of stocks and bonds falling together. Investors are wondering, what do to? Everyone hates bonds. We’ll describe a simple bond portfolio approach that can help you tackle that rising rate environment, and threat of inflation.
Ashes, ashes we all fall down.
Fairy tale nursery rhyme
And keep in mind that “threat” is the obvious word here. No one knows with any certainty where interest rates will go and if serious inflation will take hold. Interest rates and inflation were the main topics covered in my MoneySense weekly, here’s making sense of the markets.
The guessing game.
It’s a guessing game, but I looked for many expert opinions. From that MoneySense post and from economist and bond guru Lacy Hunt …
“The technological changes today are more evolutionary, not revolutionary. The production function is one of the most fundamental relationships in all of economics, and it’s telling us we’re facing a period of difficult growth. Given these other circumstances, it’s going to be one in which the inflation rate is going to be trending down, possibly at a much greater risk of deflation than inflation.”
Lacy Hunt
It is possible that we see inflation or even hyper inflation. Lacy Hunt and many other economics might be right and that we’ll get back to the disinflationary slow growth that has dominated our investment careers. It’s all we’ve known. For those readers who had the pleasure of investing through the stagflation of the 1970’s raise your hand …
Ya, nobody, I thought so. 🙂
Our stocks love disinflation.
Developed market stocks (such as Canadian and US Stocks and European stocks) just love that disinflationary environment. They’ve done well. You’ve likely done very well if you were able to buy and hold and get out of your own way.
That disinflationary (and low inflation) environment might continue. That would be my guess, but my prediction might only be as good as a real economist. Massive debts and deficits are known to be an anchor on future economic growth. We live in an era of borrowing and money printing and national debts that is in record territory. That’s certainly “not good”, and it may weight in on economic growth and any lasting inflation.
I’d guess that we get a head fake burst of inflation due to pent up demand and increased savings rates that occurred during the pandemic. And then we might get back to the largely disinflationary, low inflation trend.
But we don’t know.
Anything could happen.
The bond markets gave us a recent scare. Of course, as bond yields rise bond prices go down, they are inversely related. Investors had to watch their bond funds take a hit, just as the stocks were falling in price. Bonds were no buffer for stocks.
A core Canadian bond ETF such as iShares XBB has fallen by about 5% year to date, US long term treasuries and other long term funds have taken a greater hit.
To reduce the threat of rising rates, and to profit with greater income over time, the general counsel is to ‘go short’. That is, hold shorter duration bonds such as 1-3 year or 1-5 year bonds. Shorter duration bonds do not fall as hard when rates rise. Long term bonds will multiply that price decrease effect.
On the other side of the bond coin, it is the longer term bonds (especially long term US treasuries) that offer the greater ability to go up in price when stock markets take a hit. They punch above their weight in regards to managing stock market risk.
Here’s my overview on bonds and bond ETFs.
The bond barbell approach.
You might consider a one-two punch barbell approach, long and short.
- Short – manage interest rate risk
- Long – manage stock market risk
On the short end you might use 1-5 year corporate and 1-5 year government bonds. You might consider an ultra-short bond fund.
On the long end you can use Canadian and US treasuries.
Other bond funds that are built for inflation and rising rates are real return bonds and floating rate bonds.
Real return bonds offer yield plus an inflation adjustment.
You may also consider savings accounts or a GIC ladder for a portion of your fixed income. EQ bank has some very decent rates.
I am not a fan of reaching for yield with lower quality high yield bonds. That said, I receive generous and growing income from Canadian dividend stocks.
Here’s building the simple stock portfolio.
Oh Canada.
And not all stock markets are built the same. Certain kinds of stocks can do well in a rising rate environment and inflationary environment. The Canadian market with an overweighting to financials and energy, and decent metals and commodities exposure is well positioned. You might continue to enjoy the results of your exaggerated Canadian stock home bias.
Canadian stocks are outperforming US stocks in 2021. If that continues that may give you an opportunity to rebalance and patch up any asset allocation weaknesses such as that exaggerated home bias.
In October I had put investing in Canadian energy producers on the table, some 80% ago, ha.
For Million Dollar Journey I offered this post on investing in Canadian REITs. You’ll see that REITs can enjoy a rising rate environment. There are some interesting charts in that post.
Managing inflation risks.
From the above stock mentions you can see that there are many weapons at your disposal. The greater weapons for managing risks come by way gold and precious metals and commodities.
And you likely know that I am also investing in bitcoin.
Purpose has a wonderful one-stop inflation fighting ETF PRA – the Diversified Real Asset Fund.
I have initiated a position in that ETF. I will continue to build that over the coming weeks and months. I am also holding gold ETFs, that bitcoin fund and the oil and gas producers. I have some overlap to take into consideration.
The degree to which you might use a PRA and inflation friendly stocks may factor in to how much you shape or re-shape your bond portfolio. All said, it might be wise to use a three or four pronged approach.
You might shade these into your existing and sensible and well-diversified stock and bond portfolio.
Feel free to reach out with any ideas or questions. And keep in mind these are ideas and observations that I put on the table for consideration. This is not advice.
But there are extended periods where even the Balanced Portfolio can offer no gains. That will be of special consideration for those in retirement, or approaching retirement.
Read. Research. Invest.
Weekend Reads.
This is some good fun, and we can learn a bunch from some of the most famous and relevant investment quotes. On Savvy New Canadians here’s 100 good ones.
On Findependence Hub Jonathan Chevreau explores baskets of individual stocks once the indexed core is taken care of.
On My Own Advisor, Mark looks at the best dividend stocks, bitcoin and more.
GenYMoney gives us the heads up on the recent promotional offers at the big banks.
Eatsleepbreathefi offers a review of EQ Bank.
On stocktrades.ca Mathieu Litalien offers a very good post on the new bitcoin ETFs and the closed end funds.
And on FIGarage podcast what is a bitcoin anyway?
On lowestrates.ca removing the racial barriers to investing.
I pitched in a few stock names for this post on TawCan – the best Canadian dividend stocks from the DGI community.
Moneymaaster update for February, Meh – no motivation.
And lastly, everything is broken.
And on Mauldin Economics everything is broken. Yup.
Stocks – broken.
Bonds – broken.
Retirement – broken.
It’s a shit show. There’s more broken stuff, but I’ll leave that to you to read that post.
The good news is, that doesn’t mean that we can’t build wealth among the ruins. Mr. Mauldin will offer more ideas on that. We’ll see how that aligns with Cut The Crap Investing ‘ideas’. We just might need to use that ‘broken markets insurance’ one day.
Keep a well balanced portfolio that is ready for most anything.
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Dale
Good insight and food for thought Dale. I’m getting closer to agreeing a more diversified approach re FI and inflation may be a decent option.
Great read. And yes, people do hate bonds. My newsletter on them got little action haha, but I remain convinced they’re necessary!
Hi Sunday investor, yes bonds are boring and they don’t necessarily get the same readership as a Telsa post, ha.
I should link in this article, to your bond post.
Thanks for stopping by.
Dale
Thanks Deane, if we’re in retirement we certainly want to protect against the various economic shifts.
Dale
Hi Dale,
Great article as always, thank you.
I’m in the process of deciding on my ETF investments while I transfer my old RRSP funds over to a brokerage.
I have started a position in ZAG, would you say that covers the barbell approach? It seems to have a bit of everything – short, mid and long-term.
I find it difficult to wrap my head around bonds and bond etfs (no matter how many times I read the explanations) so I just want to set up a good bond ETF that I can forget about, except for an occasional rebalancing.
Hi Dee, you’re right it has the whole mix in one. But given that it will perform ‘in the middle’ if that makes sense. That is with respect to its average duration (that is length/duration of bonds). It looks to be above 8 years now.
You can certainly use a core bond fund, but perhaps combined with a shorter ladder or shorter bond fund that will more quickly to rising rates.
Core and short, sure. BMO has an ultra-short bond fund. ZST.
“BMO Ultra Short-Term Bond ETF has been designed to provide exposure to a diversified mix of short-term fixed income asset classes with a term to maturity of less than one year or reset dates within one year. The Fund invests in investment grade corporate bonds, and has the ability to add exposure to government bonds, high yield bonds, floating rate notes, and preferred shares.”
Dale
Thank you Dale, that is really helpful!
Very much appreciated!
hi dale
i have about 15% of my portfollio in bonds , i use td e series bond fund.
as the price of this fund has gone down alot i was thinking of buying more .
does the bond funds act the same as a stock when it goes down in price it is on sale & likely to bring in more money when it goes back up , HOPEFULLY
Hi Steve, yes the bonds are going ‘on sale’. They will deliver higher yields as the price drops. And, as rates have been rising higher yielding bonds will be added to the fund. The funds underlying yield will increase over time. That said, rates could continue to rise and continue to bring down the price and value. But the same event keeps playing out, higher yields available as the price drops, plus the total yield of the bond fund keeps increasing.
The increasing yields help to suppress the falling bond prices over time.
If you want to hold bonds that have less price risk, you would look to a bond fund with shorter duration, or you could seek high yield savings accounts and GICs.
With bonds we might want them in the portfolio as shock absorbers. We will be glad to have them in the next major correction and recession. When that is, we don’t know, of course.
Feel free to reach out with more questions.