Bonds Part 3: What Does The Yield Curve Tell Us ?

About 90% of the time (or more), the yield curve is positively sloped, which means that short-dated bond yields and other interest rates (i.e. floating or variable  rate loans) are lower than longer-dated bond yields (or 5 year mortgage lending rates, which are priced as a function of 5 year bond yields).

For borrowers, this means that prime (now 3.45%) will be lower than a 5 year fixed mortgage rate (somewhere near 5.5%  now) about 90% of the time. If your cash flow can handle changing (variable) interest payments, it is likely going to be better (less costly) to have that kind of borrowing structure over longer periods of time. Talk to your Certified Financial Planning professional (or High Rock's) to see if that is best for you.

You can also see why Canadian banks continually have record earnings. They are able to borrow at the overnight rate (currently at 1.25%) and lend at prime or higher and take out a nice 2.2% (or more) profit. They get even more when their depositors get 0% on chequing and about 1/4% on savings accounts and they lend that money at prime in the short-term or 5.5% for a 5 year mortgage. The banks love a positive sloping yield curve.

What about the other 10% of the time?

When the Bank of Canada (or any central bank for that matter) is fighting inflation, usually the economy is strong and can withstand higher interest rates. As we mentioned in part 2's discussion, as the BOC raises short-term rates (inflation fighting) long-term bond investors demand less inflation premium and yields rise less quickly at the longer end of the spectrum. When the BOC raises rates one or two times too many (it is not an exact science) as happened back in 2007, the yield curve became flat: short-maturity yields moved high enough to become even  with longer-term yields (more or less). 

Historically, this usually precedes a recession: the economy can't handle the higher interest rates any more (usually at the end or peak in the economic cycle) and begins to slow, unemployment rises, inflation also slows and the BOC now takes off the "inflation fighting" hat and puts on the "defender of the economy" hat and starts to drop interest rates: the yield curve returns to a more positive slope.

As an investor, what do you do? It is not where the yield curve is at in any moment in time, it is where is the yield curve going that becomes important:

We call this a "yield curve shift" (and this is where it all gets truly exciting, so stay with me)!!

Ready?

Let's start in late 2013, early 2014, we had a very positive (normal) yield curve. However, the events of 2015, a precipitous fall in the price of oil, had a major negative impact on the Canadian economy. The BOC cut rates (red arrow left) by a total of 1/2%. The 30 year bond yield fell by close to 1% (red arrow right). If bond prices are rising as yields fall, wouldn't you rather be invested where prices are rising faster (i.e. longer duration)? Absolutely. 

Fast forward to 2017, we are over the oil crisis thing and the economy is growing and the BOC is back wearing the inflation fighting hat and raises interest rates three times each by 1/4% (3/4%, gold arrow left side). What happened to the 30 year bond (gold arrow right side)? Yields up, prices down, but not nearly as dramatically as the shorter term part of the yield curve. If you have to own bonds (as we do in a balanced portfolio), wouldn't we rather have less portfolio impact with longer duration? Absolutely.

What is next? It depends. If the BOC continues to fight inflationary expectations (like the US Federal Reserve) all those households  with record amounts of debt and variable rate loans are going to be digging a lot deeper to service their debt at 1/4% or even 1/2% higher rates (blue arrow, left side). Not good for an economy being driven mostly by the consumer. That would likely create a flat (red line) or at least flatter yield curve. What duration would you like to have in that case? Looks to me like I would want longer duration (blue arrow, right side).

When we (at High Rock) make investing decisions (with our combined sixty plus years of bond trading experience) for our fixed income model, we make determinations on what our average duration (on the yield curve) should be for the bonds that we collectively own. We will buy and sell different maturities to make those adjustments. We may want to own a higher weight of 30 year bonds now, but we do not necessarily need to own them for all 30 years until maturity. If at some point we decide that we see a shift in the yield curve coming where it is better to have a shorter average duration of our bond holdings, we can sell some or all of them back into the secondary market to do so. Tough to replicate what we do with an ETF, so we own the actual bonds and our clients don't need to pay an MER on top of our fee. Real portfolio management at a reduced cost. What could be better?

There you go! Wasn't that thrilling? Fun for me, anyway! I did simplify things a bit, but feel free to get in touch with any questions:

scott@highrockcapital.ca