The long, short and steepness of bonds

IShares CDN Bond Index Fund (XBB) is a close proxy of the DEX Bond Universe. It has 236 holdings with a weighted average term of 8.87 years and a weighted average duration of 6. Duration is a risk measure that factors in weighted cash flows discounted to today to give you a sense of price movement with an increase or decrease in the portfolio. For example, a 1% rise in current interest rates would mean a 6% drop in price of the portfolio. The current weighted average yield to maturity is 3.59%. Roughly 70% of the holdings are government and provincial bonds while 30% are corporate bonds.

Over the last year, the price closed as low as $27.84 in October of 2008. In November, the current price rose above its 50-day moving average and rose above its 200-day moving average in December 2008. Since these points in time, the price has remained above the 200-day moving average and flirted on both sides of the 50-day moving average. On Friday the price finished off at $29.30 with no real guidance from a relative strength basis or moving average convergence divergence. The moving averages are bullish towards bonds in XBB.

The yield on a 10-year government bond has risen significantly in the last 6 months. The 10-year yield is currently at 3.49% in Canada and 3.74% in the US. Six months ago, the yields were closer to 2%, which means the increase was over 85% in the US. This is one of the fastest and sharpest rises in history due to a record increase in supply of treasuries. Recently volatility has been high with the market trying to decide which direction to bet on. In their monthly review & commentary – May 2009, ScotiaMcLeod indicated that “Volatility also remains high as the tug of war between record increased Treasury supply, (negative for bonds and causing yields to rise) versus the reality of the poor economy and government quantitative easing (positive for bonds, causing yields to decline) continues.” TD Economics reported in the Weekly Bottom Line, “As equity markets gained this week, bond yields also continued their climb, on the back of decreasing risk aversion and anticipation that inflation pressures from a quicker-than-expected recovery might force the Fed’s hand to raise interest rates sooner.” We even saw the rise in mortgage rates in Canada in various terms.
In the short term, if we have a sell off in equities, bond yields will likely fall and prices will rally (good for XBB). In the longer term, as the economy recovers yields on bonds will continue to go up and the curve will continue to steepen. Therefore, after a fall in equities you may want to shift to a more short-term bond structure (XSB). Scotia Economics changed their forecast recently, predicting a very different outlook for the next 12 months. They are calling for rising yields across the entire maturity curve, and predicting the Bank of Canada will, along with the U.S., begin raising its overnight rate as early as the first quarter of 2010. Given this outlook, long bonds (10-30 year maturities) do not look attractive and they now recommend active investors remain in the shorter end of the maturity spectrum. In particular, 2-year bonds present decent value if the Bank of Canada is indeed on hold for the duration of this year.