Stock Market: How to Profit From the New Bond Bull

No one can predict when a new bull market will start. That can only be known in hindsight.

But it certainly feels as though we are seeing the beginning of a new bond bull after the roughest two years since the 1980s-early 1990s.

The FTSE Canadian bond indexes have been flashing green since November, posting the most impressive gains we’ve seen since the Bank of Canada began its tightening cycle back in early 2022. Since then, it has raised its overnight rate 10 times, from 0.25 per cent in March 2022 to five per cent today.

In the process, it created devastation in the bond market, which seemed to expect low interest rates would last forever. Dividend stocks also suffered, as did variable rate mortgage holders who were squeezed by higher payments every time the central bank moved.

As for the economy, rising rates have been bad news. Third quarter GDP showed a drop of 1.1 per cent, putting Canada on the brink of a recession (two consecutive quarters of negative growth). While economic growth has stalled, the unemployment rate has been inching higher, reaching 5.8 per cent in October. 

All that may be over – we hope. Bank of Canada Governor Tiff Macklem hasn’t ruled out more rate hikes if inflation doesn’t fall back to the target two per cent level. And we’ve already had a false flag – it appeared for a brief time last January that rates would stabilize, sparking a bond rally that quickly fizzled.

But this time, it appears to be the real deal and the performance of key bond indexes is encouraging. The FTSE Universe Bond Index gained 4.51 per cent in November and 3.66 in December (to the 27th), pushing the year-to-date gain to 6.93 per cent. At the end of October, the index was in negative territory for 2023. 

The big difference between now and the 1980s-1990s is that interest rates are nowhere near as high today. In February 1991, the Bank of Canada rate touched a record 16 per cent. When inflation numbers finally cooled, there was a lot more room to climb down. 

With current rates at five per cent, there is less flexibility for the central banks to cut if the economy needs a boost. But a gradual retreat of even one point over the next two years would be a welcome signal to the markets, the economy, and mortgage holders.

So how can you profit from this situation? Here is one option to consider.

iShares Core Canadian Long Term Bond Index ETF (XLB-T)

Type: Exchange-traded fund

Recent price: $20.11

Annual payout: $0.756 (forward 12 months) 

Yield: 3.8 per cent 

Risk Rating: Higher risk     

Website: www.ishares.ca  

The security: This ETF invests in a portfolio of long-term Canada bonds with a maturity of more than 10 years.

Performance: If you base your investment decisions on history, you won’t want to touch this one with a ten-foot pole. The fund lost 21.9 per cent last year and shows a 10-year average annual compound rate of return of only 2.41 per cent. But, as they say, past results are no guarantee of future returns. The 2023 gain to Dec. 27 was 10.2 per cent.

Key metrics: The ETF was launched in November 2006 and has $1 billion in assets under management. The management expense ratio is 0.2 per cent.

Why I like it: Normally, I look at bond ETFs strictly from an income perspective. But right now, we’re faced with a rare capital gains opportunity. If interest rates start to decline next year, as the market expects, long-term bonds will be the major beneficiaries – just as they were the biggest losers when rates were rising.

Portfolio: The majority of the holdings (55.29 per cent) is in provincial bonds. Federal issues account for 19.74 per cent. Just over three per cent is in municipals, with the rest in corporate bonds. All the bonds are investment grade (rated BBB or higher). About 20 per cent are rated AAA. 

Risks: With bonds, the longer the term to maturity, the greater the capital gains potential. Conversely, the risk of loss is much higher. If the Bank of Canada begins raising rates again, the market price of this ETF will suffer. But if the Bank cuts, investors in this fund will enjoy some nice gains on top of the regular monthly distributions.

Distribution policy: Payments are made monthly and are currently $0.063 per unit. Distributions are not guaranteed and could change at any time.

Who it’s for: This ETF is for investors who are willing to take more risk with their fixed income securities in exchange for capital gains potential. If rates start to rise again, the units should be sold.

How to buy: The units trade on the TSX, with an average daily volume of 90,200. 

Summing up: This is a rare opportunity to score some fixed income capital gains while earning decent cash flow at the same time.

Gordon Pape is Editor and Publisher of the Internet Wealth Builder and Income Investor newsletters. For more information and details on how to subscribe, go to www.buildingwealth.ca/subscribe 

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