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(Darren Price/Getty Images/iStockphoto)
(Darren Price/Getty Images/iStockphoto)

Strategy

Make bonds your portfolio shock absorbers Add to ...

Ultra-low interest rates of the past few years have blown a hole in many investment plans, and it does not look like it will get any easier over the next few years. Central bankers in the United States and elsewhere in the developed world seem determined to stick with low rates in an effort to spur economic growth, regardless of what it means for bond investors.

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“The last 10 years, 20 years of bond investing has been easy because you have had the momentum of declining interest rates,” says Som Seif, president and chief executive officer of Claymore Investments Inc. of Toronto. The real hurdle for bond investors will appear when interest rates begin to rise. “In that kind of environment, bonds are going to be challenging because your total return is not going to have any price appreciation in it.”

Today yields on government bonds of shorter duration are running between 1 per cent and 2 per cent, and 3 per cent and higher for longer terms. With inflation averaging around 2.5 per cent annually, investors therefore are either losing a little money every year or just barely keeping pace with inflation.

That does not mean that investors should abandon bond investments, however. Fixed income holdings such as bonds play important roles in portfolios by providing a regular, predictable flow of income. They also act as a sort of portfolio shock absorber by diversifying risk.

So the question for fixed income investors really is how to best use bonds in the current environment.

Given that today’s low interest rates will be maintained for a year or two and will be allowed to rise as the developed economies improve, Mr. Seif advises investors to look closely at the short term. “If you believe that rates are going to rise, then you want to be on the shorter end of duration on government and corporate [bonds] high grade corporates at least,” he said.

The scenario of improving economies in much of the world, which would help push up rates, should also give investors more confidence in increasing their holdings in corporate bonds, high yield (not investment grade) bonds, and even emerging market bonds that will give more yield and return than government bonds. Mr. Seif also recommends floating-rate bonds, which, because they are designed to yield more as rates rise, serve as a hedge in a rising-interest-rate environment.

Retail investors are looking for yield by buying step-up bonds, corporate bonds and strip bonds, said Adam Sherban, a senior retail fixed-income trader with Dundee Securities Inc. in Toronto.

Step-up bonds typically offer higher interest rates and feature a coupon that increases in value over the life of the bond. Often this bond is callable by the issuer before the term expires and investors can expect to be bought out. Strip coupon bonds (zero interest bonds) are different in that they do not make interest payments during the term of the investment but rather the yield at the time of purchase is paid at maturity, unlike GICs, which compound interest on initial investment amounts. Strip bonds are a favourite for those looking for a lump sum payout at a future date.

That has left government bonds largely on the sidelines when it comes to retail investors, Mr. Sherban said.

“Right now government bonds don’t seem to be in vogue. People are using them for short-term cash purposes. I have seen people park money in them because they are a safe haven and they provide the ultimate liquidity. So if you think times are tough, go sink yourself into short-term government bonds knowing that you are going to get out of them quickly.”

Low rates are also forcing investors out of shorter-term bonds in their quest for yield, Mr. Sherban said. “People are getting forced to take on credit risk and also interest risk by buying [bonds of]five to 10 years and even longer. If you are not happy at 1 per cent and you want 4 per cent you are going to have to extend your term and you are going to have to accept a lower quality [of bonds]in your portfolio.”

When people think about bonds they typically think of the benchmark government variety. But the reality is that the fixed income universe has expanded.

“The bond market is huge,” said Serge Pépin, head of investments at the Bank of Montreal in Toronto. He is in favour of corporate bonds, given the expectation of rebounding economic growth. He said investors should consider investment-grade and so-called high-yield corporate bonds, once known dismissively as junk bonds.

One appeal of high-yield corporate bonds, which almost always pay higher yields than investment-grade corporate bonds, is that they are closely linked to improving economic conditions and equity markets, while not being as sensitive to rising interest rates as government bonds would be, Mr. Pépin said. “So that makes them a good diversifier to have in your portfolio and will help you get that extra yield that you are looking for and will help you keep pace with inflation if not beat inflation.”

BMO and other investment firms have developed mutual funds and exchange traded funds, such as the BMO U.S. High Yield Bond Fund. Most of the funds offered in Canada are U.S. dollar denominated because the high-yield market is far larger and more developed south of the border.

“The high-yield market in the U.S. is huge, so most high-yield bond funds offered in Canada will have a big portion invested in U.S. dollar-denominated Canadian names or U.S. names.”

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