Bonds, your new best friend

Share

Stock market plunges have a way of making the government every investor's best friend.

We saw this in May, when money poured into government bonds as the stock markets fell. The same thing happened in more dramatic fashion in the 2008-09 stock market crash. When all seems bleak and uncertain in the financial world, government bonds are a refuge. Make sure you own some.

And then make sure you've got other kinds of bonds in your portfolio, too. There are multiple risks facing investors today and you need a mix of bonds to get the best possible level of protection.

Government bonds should be the foundation, mind you. While some European governments have generated concern about their ability to pay what they own, Canada and the United States have not. And remember that governments have one weapon to help them meet their debt obligations that corporates don't. They can always raise taxes to create extra revenue.

Stick to short-term government bonds - that would be Government of Canada bonds plus provincials - if you want to take the most conservative approach. Despite uncertainties about the global economy, Canada's output is growing and will certainly require higher interest rates in the next couple of years. As rates rise, bonds fall in price. However, short-term bonds (maturing in one to five years) will fall the least.

Corporate bonds offer higher yields than government bonds, so you'll want some of them as well. Mind the risks, though. Even investment-grade corporate bonds - they have a solid credit rating - present more of a default risk than government bonds. A more concrete risk became apparent in 2008: In a global financial panic, investors want the security of government bonds, not corporate bonds. The result was a big price drop in corporate bonds.

Still higher yields are available from high-yield bonds, which are issued by companies with mediocre to shaky financials. A small slice of these bonds in your portfolio makes sense for two reasons. One, they offer much higher yields than government bonds and, two, they hold up reasonably well to rising interest rates. High-yield bonds behave much more like stocks than government bonds, so be prepared to see them lose value if the stock markets crash.

A final type of bond is the real-return bond, which ratchets up its semi-annual interest payments and maturity value as inflation climbs above a pre-set level. These bonds can be unpredictable in a non-inflationary environment, so you'll want to limit your holdings.

PORTFOLIO PLANNING Now, let's look at a plan for blending bonds or bond funds in a way that offers protection against falling stock markets and some resilience when rates rise. A foundation of short-term government and corporate bonds combined provides the anchor - let's say, 75 per cent of the bond side of your portfolio. You can accomplish this using individual bonds, short-term fixed income mutual funds or an ETF like the iShares DEX Short Term Bond Index Fund , which is 72-per-cent weighted to federal and provincial government bonds with the rest in corporate bonds.

To juice the yield on your bond holdings and provide some resilience when rates rise, let's make a high-yield bond ETF or mutual fund account for another 12.5 per cent of your bond holdings. Make the remaining 12.5 per cent a real-return bond fund or ETF to offer inflation protection.

There are any number of ways to adjust this mix to suit your own particular needs. If you're a more aggressive investor who wants extra yield, use a core holding of bonds that includes some longer-term bonds (the yields are higher) and bulk up on corporate and high-yield bonds.

For simplicity, go with a broad bond fund or ETF that covers the entire bond market, including short- and long-term bonds and government and corporate bonds.

Mutual fund possibilities in this area include:

- PH&N Bond-D

- Beutel Goodman Income

- TD Canadian Bond ETFs to look at:

- BMO Aggregate Bond Index ETF

- iShares DEX Universe Bond Index Fund

Protect your portfolio with bonds, by all means. But do it with care so that you don't end up having to protect yourself from bonds.