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By Robert Miehm | 12-22-2017

Bond fund performance in 2017

Why did long-term fixed income funds perform so strongly despite two rate hikes?

Robert Miehm: In a recent Morningstar article, we pointed out that many of the Canadian fixed income fund categories performed well in 2017 even though there were a couple of interest rate hikes in July, and again in September.

Why did we see many of these indexes go up when we may have expected them to move down in an increasing interest rate environment? We'll consider the example of the long-term bond sub-category, as it was one of the standouts, but let's briefly review what happened in 2017.

There were two moderate, quarter-point hikes in the overnight rates. The BOC indicated in their Monetary Policy Report that the increases were primarily due to stronger-than-expected economic growth and a strong labour market. Taking their expectations for inflation and growth into consideration, they settled on a 1% rate to end the year.

Uncertainties in the BOC's growth and interest rate projections are centered on 4 factors: inflation, excess capacity in the labour market, continued softness in wage growth and elevated household debt.

The latest details of the Monetary policy report from October point to the "downside risks to inflation," with Canada's inflation rates running close to their target, 2%. The moderate tightening that we saw in 2017 affected shorter term rates, as expected, but BOC policy actions typically have less of an impact on longer term rates.

Long-term rates decreased relative to short rates, causing the yield curve to flatten, as expectations of future inflation have decreased given the short rate increase. The moderate tightening by the BOC is a move toward controlling growth and inflation, which would have served to benefit bond funds holding longer term bonds. Longer-term rates are determined more by supply and demand characteristics in the market, driven by differing inflation and GDP growth expectations.

To sum up, the interest rate effect on long-term bonds was minor given small upticks in the BOC's policy rates in 2017 driven by the current state of the economy and the many uncertainties built into growth and inflation expectations. The year ahead may also be expected to have moderate increases in rates, but can always surprise whenever there is more, or less, excess capacity than expected in the economy.

For Morningstar Investment Management, I'm Rob Miehm.

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