By Lachman Balani
TORONTO: Bond funds are dependent upon the duration of the bonds (2 year, 5 year, 10 year) in the fund, their corresponding yields, and the overnight Bank of Canada interest rates. The longer the length of the bond maturities, the more pronounced the effect will be if the interest rates or yields go up or down.
There is an inverse relation between interest rates and yields versus returns on bond funds. As interest rates or yields go up, the value of the bonds go down and vice versa. Ever since 2010, financial mavens have been talking about the bond bubble, saying interest rates were so low at 0.25% in Canada that as soon as they go up, bond funds would give negative returns in keeping with the inverse relationship.
However, when interest rates did go up in 3 steps of 25 basis points each in June, July and September from 0.25% to 1% another important factor, i.e. the yields on the bonds, went down, giving rise to positive returns on the funds(10 year bond yields went down only 0.4% in that year) at around 6%.
In 2011, interest rates remained stable but yields on 10 year bonds went down more than 1%. This led to better than expected returns on bond funds in the 8% range.
In 2012, interest rates have stayed put, but yields as of Dec 24 have gone down to a lesser degree (about 14 basis points or 0.14%- each basis point equals 0.01%) than 2011 giving modest positive returns on bond funds at around 3.5% in the more popular fund companies.
The outlook for 2013 is that interest rates will not budge. Following are a few factors that certain financial gurus say point to a lowering of yields on bonds (a positive return on bond funds- remember the inverse relationship)., despite their current low yields (Canada 10 year bond yields are at 1.82% as of Dec 24).
The few factors are: projected slow growth in the US, a projected slowdown in China, the projected continued recession and high unemployment in some parts of Europe and the not so publicised news piece that the International Monetary Fund has recommended that both the Canadian (CAD) and Australian dollars become reserve currencies early in 2013.
The moment the IMF declares the Canadian dollar a reserve currency it will prompt countries that currently hold the CAD in their reserves to increase it significantly. Countries that don’t hold CAD will also get on the bandwagon driving down yields and driving up bond prices.
The current reserve currencies are the US dollar, the UK pound sterling, the Euro, the Swiss Franc and the Japanese Yen. At the moment the total amount of Canadian dollars held in countries’ reserves is only $60 billion, a paltry sum compared to the total of $10.8 trillion held as reserves by the world’s governments. The moment it is declared a reserve currency, the expectation is that there will be a huge influx of foreign currencies into Canadian dollars driving up the values of Canadian bonds.
Therefore for those looking for capital preservation with higher returns than GICs, bond funds are low risk alternatives to GICs with a potential for higher returns and still seem to be attractive. However do stay alert.
(Lachman Balani can be contacted @416-902-3580 or email@example.com)