Amid a challenging environment for fixed income, investors may want to consider alternatives to the government bonds in their portfolios.
Year-to-date, the FTSE Canada Universe All Government Bond Index has returned −5.52%; in the first quarter, the FTSE World Government Bond Index – Developed Markets (USD) returned −5.66%.
“Investors should expect low returns for government bonds in developed markets over the long run,” said Éric Morin, senior analyst at CIBC Asset Management, in a recent interview. He offered several reasons in support of his view.
First, “Interest rates are extremely low — and they’re zero in most cases,” Morin said. The Bank of Canada has held its key policy rate at 0.25% since March 2020 when the pandemic began, and the Federal Reserve’s key rate has been zero since then.
As the economy recovers and interest rates increase over the longer term, the negative impact on bond prices will be “larger than usual,” Morin said, because interest rates will be increasing from such low levels.
At the same time, despite that increase in interest rates, rates will likely converge to a relatively low level.
“Over the long run, central banks will target extremely low policy rates because of low trend inflation and elevated leverage in the system,” Morin said.
A final reason to expect low returns for developed-market government bonds is that central banks will continue their bond purchases in response to the pandemic.
Though last month the Bank of Canada announced a tapering of its asset purchases to $3 billion weekly from $4 billion, the Federal Reserve has made no tapering announcements.
Ongoing quantitative easing “will continue to put the lid on the longer head of the yield curve,” Morin said, and, as a result, investors in government bonds will continue to go unrewarded for duration exposure.
To counteract the challenges for developed-market government bonds, Morin suggested investors look for an asset class within fixed income that offers three characteristics: relatively higher interest rates, rates that won’t materially increase over the long run, and reward for risk other than duration.
“Emerging government bonds or an index of emerging government bonds is an asset class that meets the three criteria,” he said.
In its Q2 outlook report, Franklin Templeton said it favoured select investment-grade U.S.-dollar denominated sovereigns in emerging markets, from both a carry and total return standpoint.
The global investment firm said it was cautious about debt issued by “lower-rated frontier sovereign countries that face a challenging uphill road.”
If investors allocate less of their portfolios to government bonds in developed economies, they must consider their increased risk, which would depend on where investors increase their allocations, Morin said.
Increased exposure to emerging market government bonds means greater exposure to country-specific risks, and portfolios should subsequently have adequate diversification, he said.
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