January 2020 Commentary Long-term BondsSubmitted by Mark Smith-Windsor Investment Advisor on January 9th, 2020
The beginning of a decade is about the time people make predictions for the next 10 years. I haven’t a clue what will happen, nobody does. What I do believe is that the next 10 years will not be the same as the last 10. We just don’t know in what way. The military actions last week highlight this.
I’d like to discuss a commonly owned investment that I believe over time will prove to be injurious to your wealth. That is long term government bonds. At one time people purchased government bonds for safety and the yield which provided income that reduced the volatility of your portfolio. Now the yield is immaterial so one is purchasing them for capital appreciation. Let’s go over how this works. An individual who purchases a bond and holds it to maturity will earn a fixed rate provided the bond doesn’t default. The current yield maturity on a 30 year Government of Canada is 1.7%. That means the most you can make is 1.7% per year over 30 years. Not very appetizing.
Now there is a way one can make more than the 1.7%, and that is if the already low rates go even lower, or negative like they have in Europe. If you own a bond yielding 1.7%, and all of a sudden people are willing to buy bonds with a 1% yield, people will pay more for your bond you currently own. This increase in value of the bonds as rates go lower has been driving capital appreciation in bonds over the past number of years. But the fact remains if you hold until maturity you will not earn more than the yield you purchased them for.
Now the opposite is also true. If interest rates were to rise, the price of the bonds you own would fall as people wouldn’t be willing to pay as much for the low yielding bonds you owned. For example, if rates on a 30 year Government of Canada bond were to rise to 2.5%, the value of the bond would fall by approximately 17%.
Now I can’t predict interest rates and I can’t predict what will happen in the next 30 years, so I think the best strategy is to look at the current yield as a base case. The 1.7% yield is a pre-tax number, and a pre-inflation number. So the average person might have a marginal tax rate of 38.5%, and inflation is currently around 2%
|Bond yield||After tax yield (Assuming a 38.5% tax rate)||After taxes and inflation|
If taxes and inflation stayed the same over a 30 year period you can expect to lose 25% of your money after taxes and inflation.
The Bank of Canada posts a handy inflation calculator which you can use to look at the decline in purchasing power over time.
This is essentially the great challenge of investing in today’s environment. There aren’t many really safe ways of making money. You need to take on some risk. And by taking on some risk, there is the chance of loss. In my view it in the long run it is safer to take some chances, than lock in an almost certain loss over time.
That said there are always opportunities. For yield, preferred shares currently yield about 5% and are taxed more favorably than bonds. Most blue chip stocks in Canada pay out higher dividends than government bonds. And I’m going to go out on a limb and say oil stocks are cheap, and have reasonable risk reward from current levels.
Happy New Year, I hope everyone has a great 2020.
As always I am available for any questions, financial or otherwise, at 306-385-6261 or by email email@example.com