Are You Sitting on Broken Bonds?

Bonds have become return-free risk. Millions of Canadians are unknowingly exposed to them through balanced funds. It's time to find out if you're one of them.

Last week, we laid out a case for Canada’s debt doom loop. A government uninterested in fiscal anchors and reliant on fuzzy math has all but guaranteed forever-deficits, soaring debt charges, and the inflation that inevitably follows. This week, we want to talk about what that might mean for your portfolio. Specifically, why owning Canadian bonds right now may be one of the most misunderstood risks in investing.

The Rate Cycle Repeats

For forty years, bonds were the gift that kept giving. Falling interest rates meant rising bond prices, and investors were rewarded with a reliable, steady return. In so-called ‘Balanced Funds’, they served as the perfect partner to volatile stock portfolios. That era is over. Canada and much of the rich world finds itself in a structurally different environment. Record debt levels and massive deficits, mean bonds issuance is a historic pace and competing for a finite pool of global capital. More supply, same demand. Prices fall; yields rise.

The Debt Trap

It’s the feedback loop that makes this dangerous. Higher yields mean higher debt charges. Higher debt charges mean larger deficits. Larger deficits lead to more bond issuance, which in turn leads to higher yields. The loop reinforces itself, and existing bondholders pay the price through capital losses on bonds they already own. As we highlighted last week, this is the path Canada is on. Federal debt charges will likely exceed $59 billion this year. This is more than healthcare transfers to the provinces, more than GST revenues. Under the government’s own optimistic growth assumptions, that number is forecast to hit $76 billion by 2029. It will almost certainly be more.

Inflation is Coming

Inflation is the enemy of a fixed income. Higher prices erode the purchasing power of a steady stipend, i.e. a bond payment. In Canada, inflation was coming. The U.S. attack on Iran and the subsequent energy supply shock guarantee it. The Bank of Canada now faces an impossible choice. It can look through the spike and risk that inflation expectations become unanchored, or raise rates into an already weak economy. There is no good option. Either inflation erodes the real value of bond returns, or higher rates directly hammer bond prices. Either way, bondholders lose.

Bonds are Dead Weight

None of this should come as a surprise. The last five years have already delivered the lesson. Even accounting for interest payments, the total return for the Canadian bond universe is zero. Accounting for inflation, investors have lost money in real terms. That poor performance was punctuated by a brutal drawdown in 2022. One of the worst years for bonds in modern history. Return free risk. That is not an anomaly. It is a preview of what happens when inflation returns, and rates rise in a world drowning in government debt. Some of the investors who would have been worse off were those in balanced funds. Products marketed as low- to medium-risk experienced equity-like drawdowns but then underperformed due to a heavy weighting in bonds.

Are You Exposed?

Most Canadians don’t own bonds directly. They own them without knowing it, often through what are called ‘Balanced Funds.’ These funds are sold by every major bank and insurance company as a safe, diversified, all-weather portfolio, and they routinely allocate 35% or more to fixed income. The example below is not unusual. Over a third of that portfolio is in bonds, with meaningful additional exposure to Canadian and global equities that will face the pressure of a rising rate environment. That is not a low-risk portfolio. This is a portfolio with significant, largely unacknowledged exposure to the world we have just described — fiscal deterioration, inflation, and rising yields.

Return Free Risk

If bonds are really a safe haven, then the logic is simple: when the economy weakens, central banks cut rates, bond prices rise, and your portfolio is protected. But that world no longer exists. It assumes governments are fiscally prudent, the supply of bonds is manageable, and inflation is contained. Canada and many other rich-world economies fail on all three counts. Structural deficits, a productivity crisis, a record share of bonds held by potentially fickle foreign investors, and an inflation wildcard have fundamentally altered the risk profile of Canadian fixed income. Investors sitting in balanced funds believing they are protected need to look again. The downside risks are real; the upside is not.

-rd