The Long and Short of it:The benefits of longer-term bonds

N E W T H I N K I N G

Yields on 10-year U.S. Treasury bonds dropped from 15% in 1982 to 1.5% in 2016, creating a 30+ year bull market for bonds. After reaching the low of 1.5% in the middle of 2016, yields rose more than 100 basis points, resulting in a large sell off in bonds and leaving some investors asking if it’s time to say “so long” to longer-term bonds.

Generally speaking, for investors who hold very conservative fixed income-focused portfolios with little or no equity exposure, it may be. Longer-term bonds provide two key benefits: (i) diversification from equities and (ii) stable returns. Given the limited equity exposure in this type of portfolio, these investors do not need the diversification benefit offered by longer bonds. In cases like this, a substantial allocation to short-term bonds may be a prudent way to reduce overall portfolio risk.

However, the vast majority of investors hold a broader range of investments and have at least some equity exposure. For these investors, longer bonds (10+ years to maturity) continue to play a key role in portfolios. TD Asset Management (TDAM) research shows that even a portfolio with as little as 10% exposure to equities can benefit from holding longer bonds.

Benefit 1: Diversification

In the world of investing, there aren’t many “free lunches;” in most cases, you need to take more risk to generate more return. Diversification is an exception, offering hungry investors a chance to maximize risk-adjusted portfolio returns. As Chart 1 demonstrates, diversifying an equity portfolio by including bonds can reduce a portfolio’s volatility and maximum drawdown by more than 50%.

The Long and Short of it:The benefits of longer-term bonds

New Thinking | The Long and Short of it: The benefits of longer-term bonds PAGE 2

CHART 1 - Diversification Effects

January 1, 1999 – December 31, 2016 Source: Bloomberg Finance L.P., TD Asset Management

*Passive portfolio consists of 50% S&P 500 Total Return Index and 50% Barclays Aggregate U.S. Bond Index

-50%

0%

50%

100%

150%

200%

Barclays Aggregate U.S. Bond Index

Passive 50/50*

S&P 500 Total Return Index

Cum

ulat

ive

Gro

wth

-55.25%

Volatility

Max Drawdown

16.33%

-25.14%

7.94%

-5.08%

3.13%

2012 20162008200420022000 201420102006

Overall (1980 – 2016)

Correlation Average Annualized Return

U.S Long Bond5%

7.8%

S&P 500 12.3%

Cdn Long Bond15%

8.7%

S&P/TSX 9.5%

Bear*

U.S Long Bond-31%

13.2%

S&P 500 -47.2%

Cdn Long Bond-23%

7.1%

S&P/TSX -49.2%

Neutral*

U.S Long Bond6%

3.6%

S&P 500 3.1%

Cdn Long Bond19%

6.2%

S&P/TSX 4.4%

Bull*

U.S Long Bond23%

10.3%

S&P 500 38.8%

Cdn Long Bond26%

12.4%

S&P/TSX 39.5%

CHART 2 - Correlations between Longer Bonds and Equities

*Bear market = Country’s equity market performed < -5% quarterly *Bull market = Country’s equity market performed > 5% quarterly *Neutral market = Country’s equity market performed > -5% and < 5% quarterly

U.S. Long Bond is 10-Year U.S. Treasury Bond/Cdn Long Bond is 10-Year Government of Canada Bond. Source: Bloomberg Finance L.P., FTSE TMX Global Debt Capital Markets Inc., TD Asset Management. January 1980 – December 2016

Longer-term bonds have a very low correlation to equities in neutral or bull markets and have a strong negative correlation in equity bear markets, which can provide meaningful diversification and help to smooth short and medium term market trends. While longer-term bonds may lag behind stocks during equity bull markets, they have historically provided higher returns than equities during bear markets, which can help to cushion losses in balanced portfolios.

New Thinking | The Long and Short of it: The benefits of longer-term bonds PAGE 3

50/50 Fixed Income & Equity0%

10%

20%

30%

40%

50%

60%

70%

80%

90%

100%

-41%

-40%

-39%

-38%

-37%

-36%

-35%

-34%

-33%

-32%

Equity Short Bonds Max DrawdownLong Bonds

-39.9%

38%

25.0%

25.0%

13%

38%

50%

13%

-38.7%

-37.6%

-36.4%

-35%

50%

CHART 3 - Optimized Maximum Drawdown (1970–2016)

January 1, 1970 – December 31, 2016 Source: Bloomberg Finance L.P., TD Asset Management

Benefit 2: Stable returns

Bond returns are driven by two factors: income and capital gains/losses. Historically, income’s contribution to the total return of a bond has been high (on average 50%-100% over any 3-year period). With yields close to their historical lows, generating significant capital gains from bonds will be challenging given the inverse relationship between yields and bond prices. This means income is poised to become an even more crucial component of return, and the incremental yield offered by longer-term bonds versus short-term bonds should become even more attractive. As shown on the left side of Chart 4, longer-term U.S. and Canadian bonds currently provide premiums of 1.63% and 1.10% respectively, relative to shorter-dated bonds. Real yields (which take inflation into account) are shown on the right side of the chart. With short-term bonds currently providing negative real yields, investors who rely heavily on them may find it difficult to preserve the real value of their savings.

While all bonds offer at least some diversification from equities, short-term bonds have a very low negative correlation to equities during bear markets, which means they provide significantly less diversification than longer-term bonds. The chart below demonstrates that in a portfolio composed of 50% equities and 50% fixed income, longer-term bonds reduce the maximum drawdown more than short-term bonds.

New Thinking | The Long and Short of it: The benefits of longer-term bonds PAGE 4

Some investors are concerned about investing in longer-dated bonds because rising interest rates would have a negative impact on bond valuations. However, while there is potential for short-lived increases in long-term yields in the near term, TDAM’s analysis shows there is limited risk of a sustained material increase. We expect long-term yields to remain low for some time to come.

Longer-term yields declined due in part to lower inflation expectations and lower potential for economic growth. Inflation and growth are driven by supply and demand metrics, and currently supply is abundant and getting cheaper due to technology and globalization while demand is weak because of demographics (the global population is aging) and high levels of debt. These structural issues are expected to continue, which is likely to restrain interest rates.

Yields on longer-term Canadian bonds tend to be influenced by two factors: Canadian economic fundamentals and movement in longer-term U.S. bonds. Lacklustre fundamentals, such as slow employment growth and high household debt, suggest that meaningful increases in Canadian interest rates are a long way off. While short-term rates in the U.S. are likely to rise as the U.S. Federal Reserve (the Fed) continues its rate hike cycle, longer-term bond yields are unlikely to move meaningfully higher. TDAM’s examination of yield behaviour following Fed rate increases in 1994, 1999, 2004 and 2015 found that longer-term yields tend to rise in anticipation of the increase, but as the hiking cycle continues, they tend to stabilize or drop (due to fear of recession) while short bond yields may continue to rise. As an example, Chart 5 shows the Canadian and U.S. 10-year yield behaviour before and after the Fed’s first rate hike in 2004 and 2015.

U.S. Short U.S. Long Canada Short

Canada Long

0.81%

2.44%

1.63%

0.62%

1.72%

1.10%

-0.75%

0.40%

-1.35%

0.13%

U.S. 12-Month Real

U.S. 10-Year Real

Canada 10-Year Real

Canada12-Month Real

3.0%

2.5%

2.0%

1.5%

1.0%

0.5%

0.0%

-1.0%

-1.5%

-2.0%

-0.5%

CHART 4 - U.S. & Canada Long versus Short Bond Yields

Nominal yields as at December 31, 2016, Real yields as at March 31, 2017 Source: Bloomberg Finance. L.P., TD Asset Management

The information contained herein has been provided by TD Asset Management Inc. and is for information purposes only. The information has been drawn from sources believed to be reliable. Graphs and charts are used for illustrative purposes only and do not reflect future values or future performance of any investment. The information does not provide financial, legal, tax or investment advice. Particular investment, tax, or trading strategies should be evaluated relative to each individual’s objectives and risk tolerance. Certain statements in this document may contain forward-looking statements (“FLS”) that are predictive in nature and may include words such as “expects”, “anticipates”, “intends”, “believes”, “estimates” and similar forward-looking expressions or negative versions thereof. FLS are based on current expectations and projections about future general economic, political and relevant market factors, such as interest and foreign exchange rates, equity and capital markets, the general business environment, assuming no changes to tax or other laws or government regulation or catastrophic events. Expectations and projections about future events are inherently subject to risks and uncertainties, which may be unforeseeable. Such expectations and projections may be incorrect in the future. FLS are not guarantees of future performance. Actual events could differ materially from those expressed or implied in any FLS. A number of important factors including those factors set out above can contribute to these digressions. You should avoid placing any reliance on FLS. TD Asset Management Inc. is a wholly-owned subsidiary of The Toronto-Dominion Bank. Bloomberg and Bloomberg.com are trademarks and service marks of Bloomberg Finance L.P., a Delaware limited partnership, or its subsidiaries. FTSE TMX Global Debt Capital Markets Inc. 2017 “FTSE®” is a trade mark of FTSE International Ltd and is used under licence. “TMX” is a trade mark of TSX Inc. and is used under licence. All rights in the FTSE TMX Global Debt Capital Markets Inc.’s indices and/or FTSE TMX Global Debt Capital Markets Inc.’s ratings vest in FTSE TMX Global Debt Capital Markets Inc. and/or its licensors. Neither FTSE TMX Global Debt Capital Markets Inc. nor its licensors accept any liability for any errors or omissions in such indices and / or ratings or underlying data. No further distribution of FTSE TMX Global Debt Capital Markets Inc.’s data is permitted without FTSE TMX Global Debt Capital Markets Inc.’s express written consent. All trademarks are the property of their respective owners. ® The TD logo and other trade-marks are the property of The Toronto-Dominion Bank.(0617)

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Overall: The current yield enhancement and diversification offered by longer-term bonds

make them an important part of a well-balanced investment portfolio, regardless of the

prevailing interest-rate environment.

5.4

4.9

4.4

3.9

3.4

2.9

2.4

1.9

1.4

0.9-180 -120 -90 -60 -30 0 30 60 90 120-150

2004

2015

10-Year U.S. Treasury Bond10-Year Canada Bond

CHART 5 - 10-Year Government Bond Yields Surrounding First Fed Rate Hike (2004 & 2015)

December 13, 2003 – October 29, 2004 and June 1, 2015 – March 30, 2016 Source: Bloomberg Finance L.P.