I received two questions last week which were seemingly unrelated but in fact were closely tied together.
The first asked about the drop in the price of the iShares 1-5 Year Laddered Corporate Bond Index Fund (TSX: CBO). The second came from a worried reader who wondered why the shares in Enbridge (ENB, Financial) (TSX:ENB, Financial) had fallen more than $2 in one day - a huge drop for a normally stable stock.
What does one have to do with the other? Two words: interest rates. On Tuesday we saw a huge sell-off in the U.S. bond market. Investors dumped U.S. Treasuries as fears rose that the Federal Reserve Board would reduce its quantitative easing in light of strong housing data and a much better than expected consumer confidence reading. Those were positive indicators for the stock market but bad news for bonds. Some market watchers described what happened as "a rout" as yields on Treasuries hit their highest levels in more than a year.
When bond prices fall, yields rise. The return on 10-year U.S. Treasuries spiked to 2.17% on Tuesday while their Canadian counterparts moved to 2.07%.
The drop in bond prices explains the weakness in CBO although it's important to remember that short-term bond funds and ETFs are less vulnerable in these situations. CBO shares fell from $20.12 on May 23 to $20.02 on May 28. However, there was a distribution of $0.074 per share on May 24 so the actual decline in value was only $0.026 a share (0.13%). By comparison, the iShares DEX Long Bond Index Fund (TSX: XLB) fell from $23.12 on May 23 to $22.82 at the close on May 28. Minus the distribution of $0.0698 on May 24, the loss to unitholders was just over $0.23 per share (1%).
Higher bond yields mean a narrowing in the spread with stock dividend yields. Since stocks are considered to be more risky, buyers want a wider spread to compensate, Absent a dividend increase, the only way for that to happen is for the share price to drop. That led to a sell-off in U.S. utilities on Tuesday and Wednesday. For example, Southern Company (NYSE: SO) dropped from US$45.20 at the Tuesday opening (4.49% yield) to US$44.13 (4.6% yield) when the markets closed on Thursday.
In Canada, we saw a similar phenomenon with Enbridge. It closed on May 24 at $48.44 (2.6% yield). By the end of week, it was down to $44.97 (2.8% yield).
The sharp uptick in bond yields may be only temporary. But what we saw last week was a preview of what we can expect as the economic recovery gathers strength and interest rates start moving higher across the board. It is not only long-term bonds that are at risk in this scenario. So are all interest-sensitive securities including REITs and defensive stocks like utilities, mortgage investment corporations, and telecoms. As bond yields rise, the price of these securities will adjust downwards to compensate.
This does not mean there is anything inherently wrong with the companies. Enbridge is as solid today as it was before. It is a case of the stock market adjusting to new realities on the interest rate side of the equation.
The only way to avoid this is to sell your high-yield defensive securities before interest rates really take off. But that raises the question of where to put the money? If the economy is really in recovery mode, growth stocks are part of the answer but they are inherently more risky.
Unless you are a skilful trader, my advice is to stick with your plan. Continue to hold some fixed-income securities but stay short term. Maintain a stock portfolio that mixes both defensive and growth securities - the more conservative you are, the greater the emphasis should be on the defensive side despite interest rate risk.
A few weeks ago, I suggested taking profits on some of the stocks that have performed well for you. If you followed through, hold some of that money in cash for the time being while we wait to see how the market settles. It appears we may be heading into a period when we'll be able to buy some good-quality stocks at bargain prices
The first asked about the drop in the price of the iShares 1-5 Year Laddered Corporate Bond Index Fund (TSX: CBO). The second came from a worried reader who wondered why the shares in Enbridge (ENB, Financial) (TSX:ENB, Financial) had fallen more than $2 in one day - a huge drop for a normally stable stock.
What does one have to do with the other? Two words: interest rates. On Tuesday we saw a huge sell-off in the U.S. bond market. Investors dumped U.S. Treasuries as fears rose that the Federal Reserve Board would reduce its quantitative easing in light of strong housing data and a much better than expected consumer confidence reading. Those were positive indicators for the stock market but bad news for bonds. Some market watchers described what happened as "a rout" as yields on Treasuries hit their highest levels in more than a year.
When bond prices fall, yields rise. The return on 10-year U.S. Treasuries spiked to 2.17% on Tuesday while their Canadian counterparts moved to 2.07%.
The drop in bond prices explains the weakness in CBO although it's important to remember that short-term bond funds and ETFs are less vulnerable in these situations. CBO shares fell from $20.12 on May 23 to $20.02 on May 28. However, there was a distribution of $0.074 per share on May 24 so the actual decline in value was only $0.026 a share (0.13%). By comparison, the iShares DEX Long Bond Index Fund (TSX: XLB) fell from $23.12 on May 23 to $22.82 at the close on May 28. Minus the distribution of $0.0698 on May 24, the loss to unitholders was just over $0.23 per share (1%).
Higher bond yields mean a narrowing in the spread with stock dividend yields. Since stocks are considered to be more risky, buyers want a wider spread to compensate, Absent a dividend increase, the only way for that to happen is for the share price to drop. That led to a sell-off in U.S. utilities on Tuesday and Wednesday. For example, Southern Company (NYSE: SO) dropped from US$45.20 at the Tuesday opening (4.49% yield) to US$44.13 (4.6% yield) when the markets closed on Thursday.
In Canada, we saw a similar phenomenon with Enbridge. It closed on May 24 at $48.44 (2.6% yield). By the end of week, it was down to $44.97 (2.8% yield).
The sharp uptick in bond yields may be only temporary. But what we saw last week was a preview of what we can expect as the economic recovery gathers strength and interest rates start moving higher across the board. It is not only long-term bonds that are at risk in this scenario. So are all interest-sensitive securities including REITs and defensive stocks like utilities, mortgage investment corporations, and telecoms. As bond yields rise, the price of these securities will adjust downwards to compensate.
This does not mean there is anything inherently wrong with the companies. Enbridge is as solid today as it was before. It is a case of the stock market adjusting to new realities on the interest rate side of the equation.
The only way to avoid this is to sell your high-yield defensive securities before interest rates really take off. But that raises the question of where to put the money? If the economy is really in recovery mode, growth stocks are part of the answer but they are inherently more risky.
Unless you are a skilful trader, my advice is to stick with your plan. Continue to hold some fixed-income securities but stay short term. Maintain a stock portfolio that mixes both defensive and growth securities - the more conservative you are, the greater the emphasis should be on the defensive side despite interest rate risk.
A few weeks ago, I suggested taking profits on some of the stocks that have performed well for you. If you followed through, hold some of that money in cash for the time being while we wait to see how the market settles. It appears we may be heading into a period when we'll be able to buy some good-quality stocks at bargain prices
