Bonds Going Up?

Stocks and bonds are the two main ingredients in all balanced portfolios. Traditionally, investors think of stocks as the more risky of the two assets, while bonds are perceived as a safe haven. For most of the last 30 years, that has been true. But it’s important for investors to understand that bonds, too, carry risk – indeed, as Warren Buffett put it recently, “Right now bonds should come with a warning label.”

First, all bonds carry some risk of default: you are lending your money to the issuer, and there is always a possibility that you won’t be paid back. This risk is significant if you are buying non-investment grade bonds from companies with troubled balance sheets, though it is admittedly very low if your bonds are backed by the federal government.

Bonds are also subject to interest rate risk. When rates rise, new bonds are issued with higher coupons, and as a result the price of older, lower coupon bonds goes down. After all, no one would pay the same price for a 10-year bond with a 4% coupon when new 10-year bonds are yielding 5%. This works the other way around too: when interest rates fall, the value of existing bonds goes up. It’s this risk that should be top of mind for bond investors today.

Back in the summer of 1982, the yield on 10-year Government of Canada bond was over 16%. Then interest rates began a downward trend that would last three decades: in the early 1990s, they stood at around 8%, and by 2001 they reached 5%. Today, 10-year federal bonds are yielding less than 2%. This remarkable decline pushed the price of bonds higher and higher, leading to the greatest fixed-income bull market Canadians have ever seen. From 1982 through 2011, the broad bond market returned just over 10% a year – about double the historical average, and enough to outperform stocks by a full percentage point annually (source: Libra Investment Management).

Given these tremendous returns from bonds, it’s not surprising that investors fleeing the volatility of the stock market have been pouring billions into fixed-income funds. What they may not realize, however, is that ths bond returns of the last 30 years are mathematically impossible to duplicate. With interest rates at historical lows, there is little room for them to fall further, and therefore little possibility that the bonds you buy today will increase significantly in price.

No one knows when interest rates will begin to rise, or how quickly that might happen. However, a significant rise could lead to several years of negative returns in the bond market. Indeed, after factoring in inflation and taxes, bond investors who are getting yields of less than 2% today are already losing purchasing power.

WHAT DO WE DO ABOUT IT?

Concern about rising interest rates does not mean investors should flee bonds altogether: fixed income still plays an important role in every balanced portfolio. The key to investing in bonds today is learning to manage your exposure to the risks discussed above.

Diversification

You can lower your risk by investing in a globally diversified fund that contains bonds from various issuers, both government and corporate. This protects you in two ways: first, by holding a large number of individual bonds, you reduce the risk of significant loss if one or more of the bonds happens to default. Second, a global approach reduces you vulnerability to rising and falling interest rates, since rates in different countries do not move in lockstep.

Keep maturities short

When investors look for ways to increase their yield one strategy is to buy b onds with longer maturities. However, bonds with long maturities will fall more dramatically in price when interest rates rise. Therefore, in a low-rate environment, it is usually best to keep maturities short – say, five years or less. If rates do rise, price declines will be more modest and maturing bonds can be reinvested at the higher rates.

Focus on quality

When investors are starved for income, they may look to non-investment grade (“junk”) bonds, which have considerably higher coupons than government and investment-grade corporate bonds. But reaching for yield is dangerous: non-investment grade bonds carry a significant risk of default, and over the long term have not delivered better risk-adjusted results. A better strategy is to focus on the highest quality bonds and, if desired, take extra risk on the equity side, where it is more likely to be rewarded.