While stocks have been distressingly volatile so far in 2022, what’s happening in the bond market is, for some of the sharpest minds in investing, more troubling. Since January 2021, the Bloomberg Global Aggregate Index, a benchmark for government and corporate debt, has fallen 11 percent in USD or 12.3 percent in CAD. It’s the worst drawdown in history for global bonds and it’s put the asset class that pays an income stream of about 2 percent into a deep hole that will be hard to climb out of. About US$2.6 trillion in value in what’s supposed to be safe securities has evaporated.

Worse yet, “if the bond market has a problem, at some point other markets have a problem,” says Tom O’Gorman, senior vice president and director of fixed income at Franklin Bissett Investment Management in Calgary. The virtually risk-free return on a government bond is the asset all other assets price themselves off. If bonds are in trouble, it affects how you price a dividend-paying stock, for example.

The bond market also sends signals about what’s to come in the economy with greater accuracy than the stock market, and the signs it’s sending now is that another recession could eventually come. With inflation surging above an annualized 5 percent in most developed economies, central banks are now trying to tame rising prices with multiple interest rate increases. The war in Ukraine also threatens to further disrupt international trade and hamper economic growth.

If central bankers stick to their program of rate hikes, there’s a risk of inducing a global recession. If they hold off, there’s the possibility inflation spirals out of control, mortgage rates double and the stock market crashes. “I don’t know which is worse,” says O’Gorman. “And I’m not sure I really want to find out.”

Still a place for bonds

Given that real yields—government bond yields minus the rate of inflation—have been negative for at least a year now, which has caused the fixed income portion of your portfolio to likely lose value, many investors are asking whether they should continue to hold bonds at all.

O’Gorman, despite all that’s happening with bonds today, doesn’t hesitate with an answer. “Yes, with an exclamation point,” he notes, saying that bonds “are the one true diversifier, the one true negatively correlated asset to equities.”

Consider the possibility of a major global recession. Stocks crash 30 percent and interest rates come down 1 percent. “You’ll be very happy to have a zero percent return on that fixed income,” O’Gorman explains. It could limit your overall portfolio losses, while an all-stock portfolio might plunge by nearly a third.

It’s important to remember, however, that successful investing takes a long-term view, over more than one economic cycle. Indeed, today’s bond-market challenges are simply the flip side of more than three decades of declining interest rates, which resulted in producing stock-like returns while still guaranteeing a return of capital.

As well, the more interest rates rise, the more attractive fixed income becomes as an asset class. Say the overnight rate sits at 2.5 percent and the two-year U.S. Treasury or Government of Canada bond yield is at 3 percent. “Do you know how much money is going to run to that? You could see trillions of dollars leave other places,” O’Gorman says.

The key to surviving any short-term volatility, then, lies in tactical active management. “There’s lots of things you can do within these markets,” he says.

Find a diversified portfolio

Franklin Bissett’s Core Plus Bond Fund, for instance, includes a variety of bond types, such as Canadian government, high-quality corporate bonds, U.S. high-yield bonds, levered loans and commercial mortgage-backed securities. It also employs hedging strategies, interest-rate swaps and it actively manages its currency exposure to, as O’Gorman says, “make the portfolio recession-proof.”

He suggests using this fund in tandem with the Franklin Bissett Short Duration Bond Fund, which is focused on the front end of the yield curve—bonds maturing in less than five years—to reduce volatility. “You put those two together and all of a sudden you have less interest-rate sensitivity,” he says.

Of course, there are other options. If you’re really nervous about preserving your capital, you could buy a money-market fund, he says, but you won’t earn any interest on that fund. A straight government bond fund will also be “a harder thing to own,” he says. “You don’t have any credit risk. You don’t have any yield. All you get is sensitivity to interest rates.”

However, a well-diversified bond fund, and one that owns securities across the fixed income spectrum, can provide stability and income for investors. “I like to have a steady income,” says O’Gorman. “I want a portfolio that can offer that, and our fund has one of the better distribution rates on the market. You still need some fixed income – for the income, but also for the diversification it brings to an overall portfolio.”

IMPORTANT LEGAL INFORMATION

This material is intended to be of general interest only and should not be construed as individual investment advice or a recommendation or solicitation to buy, sell or hold any security or to adopt any investment strategy. It does not constitute legal or tax advice. The views expressed are those of the investment manager and the comments, opinions and analyses are rendered as at publication date and may change without notice. The information provided in this material is not intended as a complete analysis of every material fact regarding any country, region or market.