Fixed income investing — When you have a long-term horizon
Does fixed income investing make sense when you're focused on the long term?
CIBC Investor’s EdgeJan. 02, 2024
Let’s start with some common reasons that you might put money in the long-term investment category. We’ll define “long term” as money that you won’t need to access for 10 years or more.
You might be saving for retirement or another long-term goal like children’s college education, where these events are more than 10 years away. In addition, when you’re in the early years of retirement, it’s likely that a portion of your retirement fund won’t be touched for 10 years or more, as people live longer or retire earlier. This means that some of your retirement money could still be regarded as suitable for long-term investing, even when you’re already drawing on it.
Other common reasons to invest for the long term include accumulating money for very large purchases on the “someday” wish list. This could be a property for rental income, a cottage or, sticking with the real estate theme, saving and investing to pay off the mortgage early. Some people invest with the goal of transferring money to children or grandchildren, even when that event is far in the future. You might be investing to create a substantial charitable gift. Finally, many people would just like to grow their money over the long term with no particular spending plan in mind.
What to consider when you have a long time horizon
Once you’ve determined you’re investing some of your money for the long term, a question to consider is: should you be investing in fixed income at all with those funds? If you’re looking to maximize your investment returns over the long term, there are other asset classes that have historically returned more than fixed income. With a longer time horizon, you can sit through the price swings that typically come with those potentially higher-return investments — stocks and real estate are good examples. While these assets are potentially more profitable than fixed income, they’re riskier and possibly less liquid. However, as price volatility tends to smooth out over time, you can typically take more risk and aim to maximize your investment returns with a long time horizon, if that’s your goal.
But achieving the highest returns possible may not be the only consideration for your long time horizon investments. The traditionally more conservative returns of fixed-income products, such as 10-year Canadian or U.S. government bonds, may still make sense for part of your portfolio. What are some reasons that a long-term investor would buy bonds?
Safety and Stability
Even when an investment won’t be touched for many years, many investors aren’t comfortable with the possible volatility of an all-stock portfolio. For some portion of their portfolio, they’ll forfeit the chance to make the higher return that’s often possible with stocks and choose the typically greater stability of bonds. With bonds, they know that their money will earn some rate of return and be returned to them when the bond matures. This lets them sleep at night and makes it less intimidating to check their account statements when financial markets are in turmoil. Nothing wrong with that.
A practical way to receive investment payouts
Investors with a long investment time horizon may still be interested in receiving occasional or regular interest income from their fixed income investments. Bond ETFs or mutual funds usually make monthly distributions that can be paid out to you or reinvested into the fund — check that the fund you’re considering handles payments this way if this is an important feature for you. Individual bonds usually make less frequent, semiannual interest payments, which may also work for you, depending on your situation. For some investors, receiving bond interest payments creates a better experience than selling stock or depending on a stock dividend to receive a payment.
As interest income is taxed at a higher rate than capital gains or dividends, this is not a point in bonds’ favour. However, some long-term investors who want to hold bonds may put them in a tax-sheltered registered plan to avoid the taxable income considerations altogether.
Finally, while other asset classes, such as stocks, real estate or gold, have the potential to increase in value and generate capital gains, can bonds do the same? Let’s take a deeper dive into this question.
Can long-term bonds generate capital gains?
To answer this question, let’s look at a time when bonds were achieving quite substantial capital gains, between 1980 and 2000.
Take a look at the chart below. The first thing to notice is how high U.S. interest rates were in the years between 1970 and 2000 — for much of that time it was possible to invest in long-term U.S. government bonds that carried an interest rate of 6 to 10%. For a brief period, rates spiked to almost 16%. Interest rates rivaled the annual returns on stocks of about 13% during that time and made those bonds an attractive alternative. After a substantial increase from historically low levels, the rate of interest on a 10-year U.S. Treasury or 10-year Government of Canada bond is less than 5%, as of December 2023.
When interest rates were declining, as they were throughout the 1980s and 90s, it was possible for a bond holder to benefit in two ways. First, from the interest rate itself and second, from an increase in the value of the bond, also known as a capital gain, as rates were falling — remember that bond prices rise when interest rates decline. As a result, many long bond funds — funds that typically hold bonds with maturities of 10 years and longer — saw annual total gains of over 20% in some years pre-2000.
For such a lofty and unusual return for a bond fund, you need two conditions: interest rates must already be relatively high and must be declining. A further complication to that scenario was that you had to be able to trade the bonds to capture their rising value. The opportunity was lost if you held the bond to maturity, as the bond’s price moves to its par value at maturity.
Investors in long bond funds, rather than individual bonds, were in the right place — they could sit back and let a hopefully astute bond fund manager trade the bonds for them to capture their rising value. For individuals, bonds were not simple to trade, especially at that time. Today, the availability of bond ETFs has made this somewhat more practical, but decisions on when to sell a bond or bond ETF to lock in a capital gain are still difficult. Capturing this gain still requires an accurate way to forecast the direction and size of future interest rate moves — not an easy task.
Are interest rates likely to fall dramatically from current levels? To illustrate how unusual the movements in 10-year interest rates have been for most of our lifetimes, look at the chart below. In earlier periods, from 1920 to 1970, U.S. bond yields were much more stable and hovered around 2 to 3% for decades. From 1970 to the present day, we’ve witnessed much greater interest rate volatility.
Will my bond or bond ETF produce capital gains?
The question to ask is: “Where will interest rates go from here?” For your bond or bond fund to generate a capital gain, interest rates must decline from whatever level they’re at when you make your purchase. Interest rates have risen dramatically from the near 0% level they reached in the year 2020 — will they continue to rise or is a rate decline more likely if the economy slows and inflation drops? In addition, since this isn’t the 1980s, any decline in rates won’t occur from the 16% level, but rather from the 4 to 5% level, and any bond capital gains would be much more modest. These are some of the issues to consider when considering fixed income as an investor with a long time horizon.
Alternatives to Government of Canada and U.S. Treasury bonds
Here are some other fixed income categories to consider as a long-term investor.
Highly-rated corporate bonds, or a mutual fund or ETF that contains highly-rated corporate bonds, might be worth considering. Lending money to a corporation is generally considered riskier than lending to some governments, and corporate bonds will typically pay a higher rate of interest to compensate for the higher risk. Longer time horizons are well matched to handle this higher risk, as volatility tends to smooth out over long periods of time. Corporate bonds may carry a risk of downgrade (for higher-rated investment-grade corporates) or default (for lower-rated high-yield corporates), especially during the inevitable recessions that can occur during a long time horizon. However, sticking with highly-rated corporate bonds or investing in a portfolio that diversifies across industries, ratings levels, or both, could be options to minimize risk.
Government bonds from other countries
Government bonds from other countries may carry higher interest rates than Canadian or U.S. government bonds. Emerging market bonds in particular may present some interesting opportunities. Evaluating these offerings requires special expertise, so you’ll probably want to purchase them in the form of a mutual fund or actively managed ETF from a well-established fund manager. A professional manager will conduct the necessary research, diversify the portfolio and likely hedge out the currency exposure. As always, do your research on the mutual fund or ETF structure, risk rating, and track record before purchasing.
There are a number of fixed income choices that might make sense for an investor with a long time horizon, especially if corporate bonds and international bonds are included as potential options. As always, consider the reasons you’re choosing bonds and which, if any, fixed-income choices are likely to help you meet your portfolio goals.