The bond market had a rocky ride in 2024, although you might not have realized it if you ignored daily pricing and just looked at the value of your fixed-income portfolio at the end of the year. The FTSE Russell Canadian Universe Bond Index had a positive – and lacklustre – annual total return of 4.23 per cent. A yield of 3.94 per cent accounted for most of that.
But that return camouflages some of the volatility seen during the past 12 months, as well as dispersions within different corners of the bond market. Positioned correctly, some bond investors made good money in 2024, but others did poorly.
One forecast I can make with relative certainly is that what worked in 2024 will not work in 2025. And that’s largely because yield spreads between various segments of the market have changed substantially.
Before I make some predictions, though, a bit of a recap.
The big bond news in 2024 was that the yield curve inversion that seemed to drag on for longer than any one in recent memory finally came to an end. At the start of the year, the 10-year U.S. Treasury bond was yielding 38 basis points less than that of the two-year. The 10-year yield had been 100 basis points below that of the two-year in the early summer of 2023.
By the end of 2024, the 10-year was back to a more normal state – yielding 33 basis points more than the two-year.
Central banks worldwide in 2023 began lowering interest rates to help stem economic weakness. The United States, which had a stronger economy than Canada and Europe, has not cut rates as rapidly or by much as Canada.
The short-term Government of Canada bond index yield, with maturities of one to five years and particularly sensitive to Bank of Canada interest rate policy changes, fell from 3.73 per cent to 2.96 per cent during 2024. Yet the long-term Canada bond index yield, with maturities of 10 years or more, rose from 3.13 per cent to 3.37 per cent. This de-inversion of the yield curve happened while 10-year yields oscillated in a range of just over 100 basis points. Momentum traders had an infuriating 2024.
The weakness of the Canadian economy relative to the U.S. economy resulted in one consolation prize for Canadians: Government of Canada bonds outperformed U.S. Treasuries. The U.S./Canada 10-year spread – the extra yield offered by U.S. Treasuries – rose from 76 basis points to 134. Bond prices and yields move inversely, so that translated into comparatively better returns for Canadian bonds.
The Government of Canada 10-year bond outperformed its U.S. equivalent by just over 5 per cent. Before we get too excited, remember that the Canadian dollar fell by more than 8 per cent relative to the greenback in 2024. This is typical. The relative bond yield changes are largely offset by currency fluctuations most times. Canadians holding U.S.-dollar-denominated bonds in 2024 received currency assistance in boosting their returns.
The current U.S./Canada 10-year bond spread is 132 basis points, the most in at least four decades. Eventually, this spread will revert back to U.S. Treasuries having the smaller yield. The current spread is not justified over the long term given economic and inflation outlooks for the two countries and their relative creditworthiness.
As such, I think the Canadian dollar will eventually rally. I base this on nothing more than the relative value of the two bonds and how the exchange rate traditionally moves when yield spreads change. And yes, I know, it’s difficult to not be pessimistic about the loonie these days.
Spreads between corporate and government bonds narrowed during 2024 by roughly 20 to 30 basis points in Canada and the U.S. In the U.S., the ICE B of A Corporate Index Spread narrowed from 106 basis points to 82 basis points. This spread is now at 20-year lows. This tells us that the bond market is almost completing discounting the possibility of a recession, which would hurt the corporate bond sector, in particular.
The corporate spread narrowing, to an extent, combined with the de-inversion of the yield curve and a choppy market combined to make 2024 an unusual year for subsector returns. The strongest performing subsector was midterm corporates at a solid 8.09 per cent (which includes yield plus price). The worst-performing sector was long-term Government of Canada bonds at minus 2.07 per cent. It is highly unusual for midterms to outperform long-term and short-term issues, but 2024 was a highly unusual year. Typically, a yield curve de-inversion occurs during an overall bond rally.
Last year was a once-in-a-generation one for the bond market. The inverted yield curve, which made three-year to seven-year bonds better value than shorter or longer-term bonds on a potential return to risk basis, is now largely gone.
All the extra return a 10-year investment grade corporate bond provides would evaporate if spreads between corporate and government bonds widened out by about 10 to 15 basis points. So be cautious on corporates. Spreads can increase dramatically during significant stock market declines and credit crises.
With U.S.-Canada spreads already at all-time highs, I expect the U.S. bond market to outperform Canada in 2025. However, be aware that the U.S. dollar strength in general and against the loonie, in particular, may reverse. We can expect president Donald Trump to put pressure on the Federal Reserve’s Jerome Powell to lower interest rates, as Mr. Trump did during his first term. Lower rates would likely pressure the U.S. dollar.
Meanwhile, Mr. Trump’s economic policies will likely have varying effects. A trade war could lower economic growth, with the incoming U.S. administration underestimating the negative effects that tariffs would have on the American economy. Tax cuts will be stimulative. Big cuts in government spending will initially slow the economy but will ultimately bring longer-term benefits.
The ratio of tax reductions to spending cuts will be important. During Mr. Trump’s first term, deficits remained large and increased even before the COVID-19 lockdowns. Mr. Trump said little in his election campaign about seriously addressing deficits and the debt. Soaring deficits, and pressure to lower interest rates too much, may ignite inflation. This is a not an insignificant risk.
I believe that with long bond yields hitting new multimonth highs this month, bonds are excellent value. There is greater scope for yields to eventually retrace lower, especially in the U.S., which means there will be price gains to be had.
An index ETF of long-term bonds should perform well, especially one with U.S. bonds but with the currency hedged back to Canadian dollars.
Tom Czitron is a former portfolio manager with more than four decades of investment experience, particularly in fixed-income and asset-mix strategy. He is a former lead manager of Royal Bank of Canada’s main bond fund.