Beware, bonds suffer with rising rates

The conservative investors who made bond funds one of the most popular mutual fund products last year are vulnerable to future losses that could be surprisingly harsh.

Using a common measure of a bond fund's sensitivity to rising rates, it's possible to estimate that many of the most popular bond funds could lose 6 per cent over a period when interest rates rise by 1 percentage point and 12 per cent if rates rise by 2 points.

This is bad news for the investors who had poured a net $11.3-billion in bond funds through the first 11 months of 2009.

This buying spree was based on the idea that bonds are safe, which is not always true.

Bonds, mainly government bonds, were a lead shield against the stock market's toxic rays during the worst of the bear market.

But with interest rates expected to rise in the next two years, bonds are set to fall in price.

Let's put this risk in perspective.

For those who own individual bonds from governments and solid companies, falling prices are nothing more than an annoying distraction if they wait patiently until their bonds mature.

The problem with bond funds, and bond-focused exchange-traded funds, is that they never mature.

Instead, they perpetually ride a cycle where they increase in value when interest rates decline (that's the 2009 story) and fall in value when interest rates increase (that's the widely expected 2010-2011 story).

True, the declines are mild compared to stocks. The year 1994 was a bad one for bond funds and the average loss in the category was 5.4 per cent. In 2008, a horrendous year for stocks, the Canadian stock market fell 33 per cent.

But if you've been investing in bond funds lately, it's probably because you're averse to losses, period.

A standard way to measure a bond fund's sensitivity to changes in interest rates is called duration.

Technically speaking, duration is the number of years it takes to recoup the cost of buying a bond. For a bond fund, you just take the weighted average duration for all the bonds it holds.

David O'Leary, manager of fund analysis at Morningstar Canada, said you can measure a bond fund's rate sensitivity by multiplying its duration by the amount you believe rates will rise.

The accompanying chart shows that big bond funds tend to have an average duration of about 6 years. This tells us that if rates rise by one percentage point, then these funds will fall in price by roughly 6 percentage points.

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"There certainly is risk in a bond fund," Mr. O'Leary said in describing the story that duration tells.

There are several variables in determining how well duration represents the risk in a bond fund in a rising rate environment, Mr. O'Leary said. For example, a fund with shorter-term bonds (five years or less) should hold up better than one with longer-term bonds. Corporate bonds could be a help to a bond fund, too, because they're partly influenced by business conditions. If rates are rising, that suggests a strong economy.

Rough as it may be, duration does provide an idea of how much potential downside there is with a bond fund (note: duration also shows the upside if rates fall). Now, maybe you're willing to live with that risk because you're happy with the interest payments from your fund. If that's the case, then be sure you know how to measure the return of a bond fund so you can compare it to the risks of owning it.

This is a particular issue with bond ETFs, which appear on investing websites like Globeinvestor.com with yields of 2.6 to 4.9 per cent. These numbers are based on the quarterly interest payments made by these ETFs in the past 12 months. These payments could move lower in the next year, which means a lower yield.

If you're looking at bond ETFs with an eye toward buying, then visit ETF company websites to find data on something called weighted average yield to maturity. Subtract the fund's management expense ratio and you have a snapshot of what your returns (interest plus price movements) might look this year if current conditions stay the same. They won't, so regard this number as a mere indication.

Let's consider the popular iShares CDN Bond Index Fund , which in an online quote shows up with a yield of 4.4 per cent. If you went to the iShares website at ishares.ca yesterday, you would have seen a yield to maturity for this ETF of 3.17 per cent. Subtract the MER of 0.3 per cent and you get 2.9 per cent.

Having a properly diversified portfolio means owning some bonds or bond funds - that's Investing 101 stuff. But overdoing it on bond funds will hurt you over the next two years. The losses could be harsh.

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Duration investigation

One way to measure a bond fund's sensitivity to interest rate swings is to look at the average duration of the bonds in its portfolio. Duration measures how long it takes to make back your investment in a bond. The higher the duration, the harder a fund will be hit if rates rise and the more it will benefit if rates fall. Here's a look at the duration of the largest bond mutual funds and ETFs.