Sandy Liang: In the post-pandemic years, it has not been fun to be a bond manager, at least for the traditional ones
By Sandy Liang
But all good market cycles come to an end.
Over the five years ending May 31, 2024, the iShares Core Canadian Bond Index ETF, a broad portfolio reflecting the Canadian bond universe, delivered negative cumulative returns to investors even though 2020 was a banner year for traditional bonds. Five years of investment and nothing to show for it.
This would include benchmark U.S. 10-year Treasury bonds that yield 4.3 per cent and 10-year Government of Canada bonds that yield 3.3 per cent today. U.S. and global inflation is past its post-pandemic peak, which is also favourable for bonds.
But is the bond market really at a turning point? What is different in this economic cycle compared with previous cycles and what does that mean for bond market returns?
What is different this time are the massive budget deficits. There’s been a shift in the supply and demand for Treasuries: from a pre-pandemic period of excess demand due to QE to a current state of excess supply driven by massive budget deficits in the U.S. and other major economies.
Government budget deficits are financed by borrowing, which is conducted in the bond market. An increase in borrowing means a greater supply of bonds, resulting in lower prices and higher bond yields, or the interest rate paid by governments, all else being equal.
The fair value of Treasury yields includes an inflation component because investors must be compensated for the loss of spending power over time. In the entire post-financial crisis period up to the global pandemic, bond prices were above fair value and bond yields were below fair value.
There is a strong possibility that bond prices will be below fair value and bond yields above fair value for much of this next bond cycle, which has already begun with poor returns. This cycle could last as long as a decade unless the U.S. changes course on its fiscal deficit spending as projected by the CBO.
Compared with the post-financial crisis period, when bonds traded higher, this time is different. The Fed can’t just print money to cover deficits. And the supply of bonds coming from massive budget deficits is expanding even as a number of other traditional large buyers of U.S. Treasuries — including the Fed as well as China and Japan — have been reducing holdings.
Massive budget deficits unique to the current economic expansion have the potential to pressure government bond prices lower and yields higher compared with their fair values. If there is an economic slowdown, the supply of bonds will be even more elevated as budget deficits grow.