How will bonds be affected by variable mortgage risk?

While the steep rate hikes of the past nearly two years have brought acute pain to variable mortgage holders, they’ve also breathed new life into the universe of fixed income.

That’s one of the main takeaways from a recent asset allocation report by PIMCO, which contends that “bonds have rarely been as attractive as they appear today.”

Fixed income’s value trifecta

Erin Browne, managing director and portfolio manager and one of the authors of the report, says that comes down to a “trifecta” of features that have traditionally been the sources of value to bond investors.

“The first is through the real carry that they offer to investors,” says Browne. “With two-year bonds trading with north of 5% today, and 10-year bonds trading with 4.4%, that’s a positive real return when you subtract out inflation, which is quite attractive and significant for investors.”

Taking 4.4% yield as a starting point, she says investors in a 10-year bond today could expect an annualized return of 4.4% over the next 10 years. Those invested in a 2-year bond yielding 4.87% today, meanwhile, could expect to earn close to a 5% return over the next 10 years.

Following the selloff in bonds over the past couple of years, Browne adds that bonds today offer real potential for capital gains, particularly as the Federal Reserve appears to be nearing the end of its rate-hiking cycle. PIMCO expects the Fed to be largely on pause for the first half of next year, setting the stage for positive price appreciation.

“The third piece of value from fixed income is diversification against risk assets, specifically equities or credit, in your portfolio,” Browne says. “Certainly that wasn’t the case over the last couple of years as the Fed hiked rates and we saw stock-bond correlations slip and go positive. But we think that fixed income is going to return to its historically negative correlation to equities as inflation is coming down.”

Variable mortgage risk: a bond blessing in disguise?

Comparing Canada with the US, Browne says Canada outperformed materially versus the US. That was driven by a slew of economic data showing the Canadian economy faring much more poorly than the US under the pressure-cooker conditions of high interest rates. In PIMCO’s view, she says that marks the beginning of a broader trend, as signs of stress from mortgage resets start to manifest in Canada.

Given the higher percentage of variable-rate mortgages in Canada, she says Canadian consumers are likely to get hit hard moving forward through 2024. The upshot, from PIMCO’s point of view, is that there’s medium- to long-term value to be had in owning Canada over the US, particularly on the front end.

How could things unfold in the US and Canada’s fixed-income head-to-head next year? PIMCO sees two potential scenarios.

“The first is you get coordinated disinflation from both the US and from Canada, which allows the Fed and the Bank of Canada to ease together. And that's currently what's priced into the curve,” Browne says. “In this scenario, you’ll probably see both bond markets rallying up on a relative basis, and there's not much outperformance from Canada, but you’ll do well owning bonds.”

Under the second scenario, which Browne says is more consistent with what PIMCO is seeing, is that the US economy will slow more gradually than the Canadian economy, which allows the Fed to remain on hold for longer given still elevated inflation. Canada’s economy, meanwhile, would have to ease more quickly as it contends with a much worse economy. The upshot, she says, is that Canada would materially outperform the US overnight rates.

“The data we're thinking about right now all suggest that growth has slowed much faster in Canada, given the combination of higher household leverage and faster mortgage resets of five years,” Browne says. “We think this is going to continue to drag on Canadian growth next year, and likely lead to Canadian bond outperformance.”

Generally speaking, she argues 2024 is prime time for bonds, with developed market bonds especially making sense for investors. Markets with higher exposures variable mortgages, she adds, are going to be more sensitive to high mortgage interest rates, as they experience mortgage resets at a faster clip. The resulting greater vulnerability an economic growth slowdown, she says, should lead bonds in those markets to outperform.

“Diversification across portfolio management always make sense. I wouldn't put suggest that you put all of your eggs in one basket in any environment,” Browne says. “But I do think that the base case is for Canadian bonds to outperform, as well as other countries that have high variable mortgage rate risk.”