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The bleak outlook for bonds is not a reason to abandon them altogether. (Dmitry Kalinovsky/Getty Images/iStockphoto)
The bleak outlook for bonds is not a reason to abandon them altogether. (Dmitry Kalinovsky/Getty Images/iStockphoto)

PORTFOLIO STRATEGY

Bond returns: How to avoid the interest-rate steamroller Add to ...

The unthinkable is taking shape for all the people who turned to bonds in recent years as a more dependable alternative to the stock market.

With 2013 just about two-thirds done, bond funds are well on their way to their first money-losing year since the 1990s. Broadly diversified bond funds are down in the 3- to 4-per-cent range on a year-to-date basis. Much bigger losses have been logged by more specialized niche funds, notably those investing in long-term and real-return bonds.

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While the Canadian stock market remains marginally lower than it was when the global financial crisis hit five years ago, the benchmark DEX Universe Bond Index returned 5.4 per cent annually. Now, investors must contend with continuing volatility in stocks and the toughest environment for bonds in decades. “We’re in a bear market for bonds,” said Hank Cunningham, fixed-income strategist at Odlum Brown. “I think it’s very possible we’ll have back-to-back negative years for bond funds.”

Bond funds are in retreat because the U.S. economy appears to be improving to the point where it no longer needs a concentrated diet of low interest rates to stave off recession or worse. The U.S. Federal Reserve has been keeping rates low by buying massive amounts of government bonds. Now, it’s looking ahead to reducing that support, or “tapering” in market-speak.

On the whole, it’s good news that the world’s most important economy is on the rebound. But it’s bad for bonds because higher interest rates drive bond prices lower. As prices fall, bond yields rise. The yield on the 10-year Government of Canada bond has risen to 2.75 per cent from 1.96 per cent in the past three months, an increase that reflects a big decline in bond prices.

“There’s not a fund in the Canadian fixed-income category that hasn’t lost money in the past few months,” said Christopher Davis, director of mutual fund research at Morningstar Canada.

The country’s two most popular diversified bond funds are RBC Bond and TD Canadian Bond, with combined assets of close to $22-billion and near-identical losses topping 3 per cent for the year through Aug. 21. The iShares DEX Universe Bond Index Fund, a widely held exchange-traded fund with assets of $1.8-billion, was down 2.9 per cent.

The most popular long-term bond funds have fallen roughly 8 to 10 per cent this year, while real return bonds have commonly lost 12 or 13 per cent. Floating rate bond funds – there are only a few of them – have been basically flat and thus rank among the bond world’s best performers. With a floating rate bond, the interest payments are tied to a benchmark rate and adjusted up or down as required on a monthly or quarterly basis.

Corporate bonds as a class, including long- and short-term, have been another comparative bright spot – they’re only down roughly 2 per cent for the year. Mr. Davis said one of the strategies bond fund managers can use in times like these is to add more corporate bonds into their portfolios and cut down on government bonds.

“If you look at the bond funds that have fared better in this environment, they tend to have relatively low exposure to government bonds, which are the most interest-rate sensitive,” he said.

Bond funds haven’t lost money over a calendar year since 1999, when the group declined 2.5 per cent on average. In 1994, the average loss for bond funds was 5.4 per cent. Those are the only two losing years for bond funds since 1985, which means most of the people who today own bond mutual funds and exchange-traded funds have become used to making money every year.

The bleak outlook for bonds is not a reason to abandon them altogether, Mr. Davis said. He sees bond returns in the next five to 10 years coming in well below what investors made in the past decade. But he also believes that bonds, notably those issued by governments, have the potential to stabilize a portfolio when stock markets are plunging like they did in the financial crisis.

“I still think that fixed income makes sense as part of a long-term portfolio,” he said. “Historically, it has been the case that government bonds and stocks behave completely differently and are therefore a good way to diversify your portfolio.”

Keep your government exposure to short-term bonds, which mature in five years or less and have been comparatively stable this year. Most short-term bond funds are either up or down no more than half a percentage point this year. If you use individual bonds, build a ladder of bonds maturing annually over the next five years. As a bond matures, you’ll have the opportunity to benefit from rising yields as you invest the money in a new five-year bond.

Odlum’s Mr. Cunningham suggests a defensive strategy based on holding blue-chip grade corporate bonds maturing in four or five years. As these bonds move closer to maturity, they’ll become increasingly less vulnerable to declines tied to rising interest rates, as well as to default risk. Consider issuers such as the banks, utilities such as Bell Canada, as well as names like Shoppers Drug Mart and Brookfield Office Properties, and don’t put more than 10 per cent of your bond holdings in any one issuer.

High-yield bonds, issued by companies with weaker balance sheets, have shown resilience lately because of their higher payouts to investors over blue-chip corporate and government bonds. Mr. Cunningham said high-yield bonds are no bargain after several years of strong gains, but he thinks there’s still a case to be made for having 5 per cent of your bond holdings in this sector.

He suggested the iShares U.S. High Yield Bond Index Fund (XHY) as a simple, cost-effective way to buy high yield bonds. XHY offers a yield of about 5.4 per cent and was up slightly for the year to date.

Mr. Cunningham believes a 4-per-cent yield for 10-year Canada bonds would be appropriate for today’s economic conditions, which suggests more bond declines ahead. If you haven’t already done so, now is the time to rethink the bonds and bond funds that served you well in the past five years. Keep to short-term bonds, lean more on corporates than government bonds and remember that the 30-year bull market in bonds appears to be over.

Read more from Portfolio Strategy.

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

Follow on Twitter: @rcarrick

 
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