The Days of Easy Money in the Bond Market Appear to be Over, and What Investors Can Do About It

For the better part of three decades, you might have said bond investing was easy. Simply invest in a passive broad market bond index, like the ICE BofA Canada Broad Market Index (“the Index” or “the Canadian Bond Market”), and investors achieved attractive average returns with relatively low volatility.

However, the days of easy money in the Canadian Bond Market appear to be over.

As illustrated in Chart 1, over the 5-year period ending December 31, 2024, the Index produced an annualized total return of just 0.7%, with a 6.4% standard deviation of returns. By comparison, over the prior 27-year period ending December 31, 2019, the Index produced an annualized total return of 6.3%, with a 4.3% standard deviation of returns.

Basic Bond Market Principles

To better explain the change of fortune of the Canadian Bond Market, it helps to review some basic bond market principles.

A bond is essentially a “securitized” loan – an entity borrows a sum of money (“principal”), over a specified period (“term”), where the borrower must pay the lender periodic interest (“coupon”) and return the principal to the lender at the end of the bond’s term (“maturity”).

A key relationship to understand is that between a bond’s coupon rate and its expected return – if held from issuance to maturity, a bond’s expected return is the same as its coupon rate.

However, because bonds are securitized, meaning they may be bought and sold by investors prior to their maturity, bond prices may fluctuate, exposing investors to potential capital gains or losses.

To account for fluctuating bond prices, investors tend to focus on the metric Yield-to-Maturity (“YTM”) to better assess the expected returns of bonds after they have been issued.

The two primary risk factors that drive bond price volatility are:

  1. Interest rate risk – i.e. changing government bond yields (“interest rates”). There is an inverse relationship between bond prices and bond yields; rising rates decrease bond prices, falling rates increase bond prices.
  2. Credit risk (for corporate bonds) – i.e. the market’s changing outlook on the financial health of a corporate issuer.

What has changed in the Canadian Bond Market?

Applying some of the principles discussed above, the change of fortune investing in the Canadian Bond Market can in-part be attributed to three factors.

First, lower YTM suggests lower expected future returns.

Chart 2 shows the YTM of the Canadian Bond Market and its forward 5-year annualized return since 1992. A key observation of YTM and its forward 5-Year total return is based on the R² value of 0.83, which suggests, on average, 83% of the Canadian Bond Market’s total return can be attributed to its starting YTM1.

The YTM of the Canadian Bond Market was 3.6% as of December 31, 2024, and can be interpreted as a baseline for the 5-year annualized return going forward.

Furthermore, while the YTM has increased from its all-time low in 2020, it is still relatively low by historical comparison, being below its long-term average YTM of 4.3% .

Second, greater interest rate risk.

Based on the R² value noted above, it could also then be said, on average, 17% of a bond’s expected 5-year return is derived from price volatility factors related to interest rate risk and credit risk.

The bond statistic used most for indicating interest rate risk is Duration2.

Chart 3 illustrates the historical Duration of the Canadian Bond Market, which was 7.4 years as of December 31, 2024. While the Duration has declined from its peak level in 2020, it remains above its long-term average level of 6.7 years.

Third, greater interest rate volatility.

Bond prices in the Canadian Bond Market are generally influenced by changes in longer-term interest rates, such as the Canadian 10-Year Bond yield, which is in-turn influenced by a number of macroeconomic factors including expectations around real GDP growth and inflation.

As illustrated in Chart 4, volatility in the Canadian 10-Year Bond yield started to increase in 2019, and peaked in 2022, mainly due to the rise of inflation.

It is notoriously difficult to accurately predict the future path of the interest rates, however, given uncertainties around the future path of real GDP growth and inflation in both Canada and the US, plus the wildcard of possible US policy intervention with the inauguration of Donald Trump, there remain catalysts for elevated interest rate volatility to persist into 2025.

Duration was not the way

If there is one thing investors have learned over the past five years it is that interest rate risk is a risk again, and not only a return driver as it was prior to 2020.

As illustrated in Chart 5, over the 5-year period ending December 31, 2024, bond investors could have increased returns and lowered volatility compared to the Canadian Bond Market by investing in lower-duration sectors of the bond market, namely short-term bonds (represented by the ICE BofA 1-3 Year Canada Broad Market Index) and high yield bonds (represented by the ICE BofA US High Yield index).

How can investors position themselves in 2025?

In 2025, bond investors could again be well served by selectively allocating to sectors of the bond market that produce greater YTMs than the Canadian Bond Market, and lower volatility by diversifying risk exposure away from interest rate risk.

A prudent active bond manager with the flexibility to invest across both spectrums of interest rate risk and credit risk could help investors achieve these goals.

LYSANDER FUNDS

At Lysander Funds, we offer a comprehensive suite of actively managed fixed income funds, by two of our partner managers, Canso Investment Counsel Ltd. and Fulcra Asset Management.

  1. R-squared (R2) is defined as a number that tells you how well the independent variable(s) in a statistical model explains the variation in the dependent variable. It ranges from 0 to 1, where 1 indicates a perfect fit of the model to the data.
  2. Duration is a measure of bond price volatility in relation to changes in interest rates. It is quoted in “years” and can be interpreted as the percent change in bond price for a 1% change in interest rate.

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