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Portfolio Strategy

Latest horror flick: Attack of the Bond Market Add to ...

Halloween approaches, which means it's a fitting time to talk about a potential horror movie sequel that'll just kill you if you hated the stock market downturn.

Working title: Nightmare on Bay Street II, Attack of the Bond Market.

The blood quotient should be a fair bit lighter than in the original version of this flick, wherein a berserk stock market slashes its way through the investment portfolios of a frightened populace.

There's a fiendishly ironic plot twist, though. The very people who were spooked worst by what happened to stocks are the ones who have piled into bond funds. Now, they're potential victims all over again if interest rates run higher.

This is not a done deal. A couple of weeks ago, this column looked at the possibility that the economy will struggle enough to keep interest rates low and thus sustain reasonably good returns from bonds (read it at http://tgam.ca/BzN).

Now, we look at this outlook's evil twin and what it could mean to the bond funds that have been hugely popular with investors in recent months.

The Investment Funds Institute of Canada said this week that domestic bond funds were the top seller on a net basis in September, as they have been for the first three quarters of 2009. Meanwhile, selling continues to outpace buying in equity funds, even while the stock market surges.

The perception among investors seems to be that bond funds are safe, but stocks are not. Unfortunately, this isn't quite true. When you own actual bonds, you can count on them being redeemed at face value at maturity even though they may fall in price (assuming they don't default). Not with a bond mutual fund or exchange-traded fund, though. They never mature, which means their value will rise and fall over time as interest rates fluctuate.

So, yes, you can lose money in bond funds. Are you ready for that?

"It doesn't take as much of a shock to spook a bond investor because they're already more conservative by nature," notes Dan Hallett, president of Dan Hallett & Associates Inc., a Windsor, Ont.-based investment research firm. "They don't expect to lose any money."

Mr. Hallett has found that from 1980 through the end of September, the average Canadian bond fund lost money about 8 per cent of the time on a rolling 12-month basis (that means taking a 12-month slice of data, say January through December, then bumping it ahead by a month to February through January, and so on.).

The year 1994 is a great one for bond market scare stories. Mr. Hallett described it as "the poster child for terrible bond markets" thanks to an inflation-fighting upward spike in rates. The average Canadian bond fund lost 5.4 per cent that year and almost all funds lost at least something.

Mr. Hallett said the typical Canadian bond fund would hold a portfolio of bonds maturing in an average of 6 years. A rough rule of thumb for assessing potential losses in such a fund would be to expect a decline of 6 per cent for every one percentage point rise in the yield of six-year bonds, he added.

One further point is that the speed with which rates rise will have a major effect on bond funds. Slow and steady is much better than a sudden rate spike. If you find yourself holding bond funds that have lost money, the best approach is to hang on. In looking at the past performance of bond funds, Mr. Hallett never found a two-year period in which returns were negative.

The length of time until bonds mature has a lot to do with their vulnerability to rising rates. Short-term bond funds and bond ETFs will hold up best, while those with longer-term bonds will be hit hardest. Note: short-term bond funds are a distinct category and clearly labelled as such (on average, they have not lost money on an annual basis in the past 15 years). Dedicated long-term bond funds are scarce - just a few funds, plus one ETF.

The typical diversified Canadian bond fund holds lots of government bonds, plus some debt issued by corporations. Government bonds are highly rate sensitive, corporate bonds less so. For them, there is the additional risk of the issuing company defaulting on interest payments.

A quick rule for determining how vulnerable a corporate bond is to rising rates: "The higher the credit rating, the more interest-sensitive a bond is," said Barry Allan, founding partner at bond specialists Marret Asset Management.

This means that an investment-grade corporate bond - solid enough for risk-averse pension funds to hold - will have some vulnerability to rising rates, though less than a government bond. Meanwhile, the high-yield bonds issued by weaker companies aren't affected much at all by rising rates.

"If you're in the high yield sector, you're insulated and probably will do well as interest rates rise, if history's any guide," Mr. Allan said. "If interest rates are rising it's because the economy is improving, and that's good for corporate cashflows."

Mr. Allan said the Canadian investment-grade corporate bond market is 60-per-cent made up of financial companies and 40-per-cent industrials. It's the bank and insurance company bonds that he sees as having the most vulnerability in a rising-rate environment.

The reason is that bonds issued by financial companies are trading at lower-than-average premiums over super-safe Government of Canada bonds, which is to say they've enjoyed a nice run lately. Reasons: the strength of Canadian banks versus their global competition and low interest rates, which are good for the banking business.

Meanwhile, industrial corporate bonds - names like Bell Canada, TransCanada Corp. and Enbridge Inc. - are trading with yields that are twice their average premium over government bonds for the last decade.

"If rates rise, these bonds may go down a little bit in price, but not materially," Mr. Allan said. "If you're in financials, you have the least protection."

Rising rates mean inflation is an issue, and that's positive for one final variety of bond that investors may hold either directly or through mutual funds and ETFs. We're talking here about real-return bonds, where the semi-annual interest payment moves higher if inflation rises, and so does the amount that investors get when the bond matures.

"They're the best direct hedge for inflation that is available," Mr. Hallett said. "The only issue is that prices are rich, so you're not getting a very large real yield."

A Guide to Bonds and Rising Interest Rates

By Type of Bond

Forecast if rates rise

Notes

Government

Poo

Prices will fall, although default risk is virtually nil

Investment-grade corporate

Suspect

Somewhat vulnerable to rates, but also tied to the financial health of the issuing company

High-yield

Good

Affected mostly by the health of the issuing company

Real-return

Good

Returns adjust to protect investors against inflation, which would be a trigger for rising rates

By Bond Maturity





Short-term (up to five years)

Weak

A little less vunlerable to rising rates, but would still be affected

Longer-term (five years and more)

Poor

The longer a bond has to go until maturity, the worse it could be hurt if rates rise



Follow on Twitter: @rcarrick

 

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