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Avery Shenfeld, chief economist at CIBC.
The fact that central banks have cut interest rates so dramatically has been a huge win for equity markets. It’s a main reason why they have managed to recover as much as they had in terms of rebounding from the losses that we saw when the coronavirus first hit. Not only has low interest rates, of course, helped support the economy — including the housing market in the U.S. and Canada — but at the same time, it’s also meant that the value of a company that pays a given stream of dividends or after-tax corporate profits over the future years is just simply worth that much more when you’re discounting those future earnings at such a low rate of interest. So, equities have certainly been a winner in this sort of environment and are continuing to get support from a low interest rate environment.
The biggest challenge from that environment lies on the fixed-income side. Investors traditionally might have had 40% of their portfolio in fixed-income assets as a way of reducing risks of being more heavily weighted for stocks. But the problem right now is that bonds are essentially yielding not much more than cash had traditionally yielded in a portfolio. So, in fact, if you’ve got 40% of your money in government bonds, that’s almost equivalent to what used to be the case if 40% of your money had been in short-term cash instruments. And these instruments will typically yield well below expected inflation over the next decade. We conducted this simulation, in fact, that looked at how a portfolio made up of Government of Canada bonds might perform over the next 10 years. And the problem is that if interest rates creep up slowly, it will create opportunities to roll maturing bonds into somewhat better yields, but, at the same time, will also create some capital price losses on an existing bond portfolio.
The result is that the return over the next 10 years on an all government portfolio could be less than 1% — in other words, well below inflation. That has investors rethinking how much of their portfolio they can have in those low-risk assets. It has people thinking about holding a greater share of their fixed-income portfolio in corporate bonds that have higher yields, but also looking at alternative investments that might not be quite as risky as an all-stock portfolio, but at the same time yield a little bit more than government bonds.
One note of caution on this front is that the temptation to reach for higher yields in the corporate bond market, relative to government bonds, does entail some risk, particularly if we’re talking about the lower end of the scale in terms of corporate bond ratings.
We have to still remind ourselves that we’re in a very underperforming economy right now. That, in fact, we will not be back to normal, we believe, until late 2022 or early 2023. And the long run of subpar results in some industries does expose investors to risks of corporate defaults, particularly on lower-rated bonds.
So, this is an important time for investors to be talking to their financial advisors and thinking carefully about if you’re allocating more of your fixed-income portfolio to the corporate side because, simply put, government yields are so low, that you’re doing it in a careful way that takes into account that we’re not through the worst yet of the economy. There’s still risks ahead in terms of the length of time that company performance will be weak, and, therefore, still some risks of default that the bond market at this point may not be fully pricing in, just given the temptation to go for those higher yields in this low interest rate environment.
More broadly, low rates are here to stay. We do expect that yields will slowly rise as the economy recovers, but I think the lesson from the last business cycle, when short-term interest rates in Canada never really got above 2% and they weren’t much higher in the U.S., tells us that the days in which you could earn 6% or 7% on a portfolio of bonds are probably behind us for the long term as well and makes for a more challenging investment environment in terms of investors trying to find returns without undue risk.