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Investors should brace for a bear market for bonds. (Dennis Donohue/Getty Images/iStockphoto)
Investors should brace for a bear market for bonds. (Dennis Donohue/Getty Images/iStockphoto)

PORTFOLIO STRATEGY

Preparing for the bear market in bonds Add to ...

September is notorious for stock market carnage, but it’s bonds that make veteran investment adviser John DeGoey nervous.

“For the first time in my entire career, bonds are in my opinion riskier than stocks,” said Mr. DeGoey, who recently marked his 20th anniversary as adviser. “In a very low rate environment, where rates have nowhere to go but up, you’re pretty much guaranteed to in a best-case scenario break even or, in a more likely scenario, lose some money.”

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This outlook has driven some radical strategizing by Mr. DeGoey that questions the very idea of making bonds a big part of our portfolios as we invest for retirement. His thinking on asset allocation is also driven by longer lifespans, a topic I’ll address in next week’s Portfolio Strategy column. But concern about bonds is paramount.

Mr. DeGoey is a portfolio manager with Burgeonvest Bick Securities and the author of The Professional Financial Advisor III: Putting Transparency and Integrity First. Recently, he’s begun the process of reconfiguring client portfolios to prepare for trouble in the bond market. “I am telling clients that they need to think about the possibility of reducing their exposure to fixed income.”

Concern about bonds began during the summer, when the U.S. Federal Reserve said it would start as early as this month to taper a program that had the effect of keeping bond yields – interest rates, in other words – low. This week, the Fed surprised a lot of people by maintaining the status quo. Low rates are good for bonds, so they rallied on this news. Rising rates would send the price of bonds lower.

Mr. DeGoey believes it’s still a matter of when – not if – the Fed allows rates to rise further. “It has already taken longer than I expected to materialize, but I remain as confident as ever that when the hikes come, traditional bond investors (especially in no fixed-maturity products like mutual funds and ETFs) will be hurt by the news,” he wrote in an e-mail.

Here’s an example of what he’s doing as a result of his view on bonds: A client with a portfolio weighting of 60-per-cent stocks and 40-per-cent bonds might be switched to a 70-30 mix. The money coming out of bonds would be split evenly into five asset classes – Canadian, U.S., international and emerging market stocks, as well as hard assets such as real estate, commodities or precious metals.

The 30-per-cent weighting in bonds doesn’t actually go into bonds. Believe it or not, Mr. DeGoey has used market-linked guaranteed investment certificates instead, for roughly 80 per cent of client fixed-income holdings.

Market-linked GICs allow investors to get limited exposure to gains from the stock market while protecting against a loss of capital. You won’t lose money and, if stocks move higher over the term of your investment, you could exceed the skinny returns of conventional GICs.

The problem with market-linked GICs is that they’re designed to put greater emphasis on making money for the issuer than the client. But if you dismiss them as a product for investing know-nothings, you’ll get some push-back from Mr. DeGoey. “This is not a fool’s way of playing the equity market,” he said. “It’s a smart person’s way of playing the income market.”

To understand his logic, you need some perspective on the relationship between stock and bond returns in the past several decades. From 1950 through mid-2012, Canadian stocks averaged 9.9 per cent and bonds averaged 7.7 per cent. But in the past 30 years, bonds have done a lot better than stocks in many cases.

Quoting data from Andex Charts, a data resource widely used in the investment industry, Mr. DeGoey said bonds outperformed in the 1980s, the 1990s and the 2000s. “We’re talking about 30 years where bonds outperformed stocks, even though if you go back 60 or so years, stocks outperformed bonds by two percentage points.”

The traditional way to insulate yourself from a declining bond market is to hold bonds maturing in five years or less, emphasize corporate bonds over government bonds and include some floating rate bonds as well. But even if you did all this, it’s still possible you will break even, at best, over the next few years.

With market-linked GICs, you break even at worst. At best, you get a chance to benefit from any stock market upside over the next few years while avoiding upsets in the bond market. The market-linked GIC most recently sold by Mr. DeGoey had a five-year term and paid no interest. Instead, client returns are pegged directly to the gains in a portfolio of blue-chip stocks. Clients get the full amount of any gains in share prices, but they don’t get the dividends. “If we have a rocking bull market, I think the upside is low double digits, and the downside is zero.”

Mr. DeGoey said that when market-linked GICs aren’t available (banks only offer them at specific times), he’s suggesting clients consider using an exchange-traded fund that holds dividend-paying stocks. It’s called the Vanguard FTSE Canadian High Dividend Yield Index ETF (VDY) and it makes monthly dividend payments that these days offer an annualized yield of about 2.4 per cent.

With a management expense ratio of 0.35 per cent, VDY is much cheaper to own than bond mutual funds and almost as cheap to own as many bond ETFs. There are 81 stocks in the VDY, and they range in size from Royal Bank of Canada to First National Financial Corp. Financial stocks are by far the biggest component of the fund at 59 per cent, while energy takes second spot at 28 per cent. The other eight stock market sectors account for 5 per cent or less.

Controversial is a polite word to describe the substitution of dividend-paying stocks like those in VDY for bonds. Stocks are prone to bigger price fluctuations – remember the 33-per-cent plunge for Canadian stocks in 2008 – and companies can cut or suspend dividends if required for business reasons. A bond defaulting on its interest payments or redemption at maturity is a rarity.

Mr. DeGoey is discussing the idea of swapping dividend stocks for bonds on a client-by-client basis, and he recognizes that some people won’t go for it. He simply wants to be able to make his case about the relative risks in stocks and bonds looking forward.

Will Mr. DeGoey’s radical rethink of bonds make a portfolio more or less aggressive? This is a question that regulators, as well as investors and advisers will have to consider as we brace for what could be the unwinding of a 30-year bull market for bonds.

“Regulators would actually say I’m making my portfolios more aggressive,” Mr. DeGoey said. “I would respectfully say that in this unique context, I am actually taking risk off the table.”

Read more from Portfolio Strategy.

For more personal finance coverage, follow Rob Carrick on Twitter (@rcarrick) and Facebook (robcarrickfinance).

 

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