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Are predictions of economic uncertainty already baked into bond prices?

To some degree, yes — but true price discovery may be more elusive in bond markets

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Uncertain tidings about equities and inflation continue to be concerning to investors who may want to adjust their portfolios. But is current news about markets already baked into the 12-month bond market, or is bond price discovery still inconclusive?

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“The short answer is that it’s a little bit of both,” says Timothy Hicks, chief investment officer at Lysander Funds Limited, an experienced, Canadian, independently-owned investment fund manager. “We’re always looking at what the markets are implying about factors such as where interest rates might be going in the future. The more important thing to note is that the expectations of the market are not necessarily correct.”

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Hicks notes, for example, that markets have become extremely responsive to the words of Federal Reserve chair Jerome Powell. In June, the Federal Reserve (“Fed”) message indicated that previously projected increases in interest rates might slow down because there were some indications that inflation had peaked. The market reacted positively and both equity markets and corporate bonds rallied.

However, with a more recent hawkish tone from the Fed, and promises of forceful increases in interest rates to get inflation under control, those same markets have retreated.

“Our view for a while now has been that inflation is going to be higher and tougher to get rid of than people seemed to anticipate and that informs our current conservative positioning,” Hicks says. “I think the market is now increasingly coming around to that view, especially with tight labour conditions and significant wage pressure.”

He notes, however, that price discovery for bonds is more opaque than it is for equities. There are few participants in the over-the-counter (OTC) bond market and many of those participants are large, institutional investors who make extremely large trades at prices that may not be published. At the same time, bonds trade less frequently than stocks.

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Essentially, it’s the role of bond experts, such as Canso Investment Counsel, the portfolio manager for certain Lysander Funds, to gather enough intelligence to price the bond market accurately. Among the skills valued by the investment team is the ability to analyze the health of each borrower and assign a level of risk to the likelihood of repayment according to proprietary analysis, then balancing risk against reward.

Hicks notes that government bonds generally present the lowest risks because, no matter the condition of the economy, money can be printed to repay the lender when the bond comes due. However, those bonds tend to offer fewer rewards in return for eliminating the risk of non-payment.

“For corporate bonds, we need to know if the borrower’s company is healthy enough, or owns enough assets, to ensure they pay us back when the bond comes due,” says Hicks. “Unlike stocks, we’re not considering the future prospects of the company beyond repaying that bond. We just need to consider the worst-case scenario for each bond offered and decide that taking on the risk of lending comes with adequate compensation.”

For long bonds, lenders must also take duration risk into consideration to price a bond accurately.

“When inflation is a concern, you have to ask yourself whether a bond will perform better than inflation,” Hicks says. “If I buy a bond offering 3 per cent over 30 years and inflation turns out higher than that, I’m going to be worse off over 30 years as the value of my investment erodes. You have to understand what those bonds are worth today, even as you’re projecting the value of returns into the future.”

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Bid-ask spreads are also greater on corporate bonds, requiring the buyer to perform significant research before making an offer — and then knowing when to buy or walk away.

“Bid-ask spreads are narrower on government bonds because they trade more frequently, aiding in price discovery,” Hicks says. “The private market is, in some ways, like a used car dealership. The dealer may set a price, but if the bid-ask spread is too great there may be no buyers. In that case, a bond’s current market price may be unknown until the bond is sold.”

For investors, then, price discovery is most often outsourced to bond fund managers who possess the skills to monitor OTC transactions, understand markets and price risk accordingly.

“Investors have to decide whether they have confidence in the bond fund manager, in the track record of performance of that firm’s bond funds, or in the current positions held by that investment firm on the future of the economy,” says Hicks. “If you have a strong view about how the markets are going to unfold and want your bond investment to reflect that, you can look at the positions and strategies of the bond fund managers and see what makes the most sense for you.”

For more information on Lysander Funds, visit: www.lysanderfunds.com

The views and information expressed in this article are for informational purposes only. They are not intended as investment, financial, legal, accounting, tax or other advice and should not be relied upon in that regard. Commissions, trailing commissions, management fees and expenses all may be associated with mutual fund investments. Please read the prospectus before investing. Investment funds are not guaranteed, their values change frequently and past performance may not be repeated.

 ®Lysander Funds is a registered trademark of Lysander Funds Limited.

 This story was created by Content Works, Postmedia’s commercial content division, on behalf of Lysander Funds Limited, who is a member and content provider of this publication.

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