In terms of what this could mean for the Canadian bond market, we’ve already seen the bond market sell off this year as expectations for the number of rate cuts have cooled. In January, the futures market was pricing in five to six rate cuts for both the U.S. Federal Reserve (the Fed) and the BoC. Now the market is only pricing in one to two cuts for Canada this year and only one cut for the U.S. in Q4.
With inflation coming down — though still pretty sticky — and with the BoC raising its neutral rate, what should the playbook be for Canadian bond market investors? Before we answer that, we must first understand what it means when we say the BoC is raising its neutral rate. The neutral rate is where the BoC expects its overnight rate to be over the long term. And it now believes its neutral rate is between 2.25% to 3.25%, as opposed to what it previously expected, which was between 2% and 3%. So even with rates starting to come down, they’re still substantially higher than where the BoC believes the rate needs to be to keep inflation in check long term.
The expectation that interest rates will continue to fall over time is still positive for the bond market. In fact, it signals that investors should be taking advantage of the higher rates we’re still seeing available. This is particularly the case for shorter-dated maturities. Because the yield curve is still inverted, shorter-dated bonds offer higher yields than bonds with longer-dated maturities.
Accordingly, one opportunity that we continue to see are target maturity funds. These funds enable investors to participate in a number of bonds simultaneously, each with the same time to maturity, such as one, two or three years. If you hold bonds to maturity — and this is the important factor — you aren’t exposed to day-to-day changes in interest rates. Rather, you’ll receive the yield to maturity that you get at the time of investment, and you get the principal back at maturity, hence the name fixed income.
Because fixed-income instruments like 3-year Canadian government bonds are yielding close to 4%, and 1-year bonds are still close to 5%, depending on your income, investing objectives time horizon and other personal factors, a target maturity fund with these maturity dates may be worth considering.
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