Stop worrying so much about bonds.
Yes, individual bonds and bond funds will fall in price when interest rates start to rise, as they eventually will. But some research by Ghattas Dallal, a senior analyst with CIBC World Markets, suggests bonds at their worst are much less risky than stocks.
“Bonds are low-volatility investments,” Mr. Dallal said. “We stress-tested bonds over the past 61 years of market data and we figured out that the downside risk for them is contained.”
Mr. Dallal’s research shows the worst period for Canadian bonds ran from June, 1980, to July, 1981, a period of soaring interest rates and rampant inflation in which the prime rate at the big banks surpassed 20 per cent.
The total return for the bond market then – price change plus interest paid – was a loss of 11.4 per cent, according to Mr. Dallal’s research. That’s a sharp decline, no question. But it’s nothing compared to these stock market declines in 2008-09:
– The S&P/TSX composite total return index (including dividends) fell 48.5 per cent from peak to trough.
- The S&P 500 index fell almost 41 per cent in Canadian dollar terms, including dividends.
- The MSCI World Index fell 41.8 per cent in Canadian dollars, including dividends.
Investors bonded with bonds as the stock market crashed because they fulfilled their mission of providing stability in dangerous times. Now, with interest rates expected to rise when economic growth firms and inflation creeping into the economy from high oil and food prices, there’s growing concern that bonds are going to be a money-losing investment looking ahead.
Maybe so. But getting rid of your bonds or bond funds is the wrong approach. Re-jig your bond holdings, sure. But stick with bonds in general and don’t sweat the downside if you have a long-term perspective.
“Bonds are an essential element of a diversified portfolio,” Mr. Dallal said. “You cannot live without bonds.”
Investors have a clear tendency to jump in and out of bond funds. In June, a scary month for stocks, the mutual fund companies that are members of the Investment Funds Institute of Canada reported net sales of $214-million in Canadian bond funds. Over the first six months of the year, a period of optimism on the whole, bond fund redemptions exceeded purchases by $747.5-million.
The smart approach: Figure out a sensible mix of stocks and bonds for your portfolio based on your age, risk tolerance and returns required to meet your goals. Then let it ride.
One reason why investors get overly torqued about bond risk is a tendency to focus too much on what the Bank of Canada is doing with rates. Mr. Dallal said the typical investor’s bond holdings are influenced mainly by what’s happening with medium- and longer-term bonds. If a central bank pushes rates higher, these bonds won’t necessarily be affected.
In 2005, he points out, the U.S. Federal Reserve raised its reference rate by a very sharp two percentage points in total, while the yield on the 30-year U.S. Treasury bond actually fell 0.29 of a point.
Inflation is the big driver of prices for the kind of bond portfolios that individual investors have, Mr. Dallal says. And what happens when inflation builds? For answers, he looked at bull and bear markets in the Canadian bond market going back to January, 1950. Bear markets were defined as a prolonged decline of 4 per cent or more, while bull markets were defined as a broad upward move in bond prices.
The average bear market for bonds was a decline of 7.1 per cent lasting eight months, Mr. Dallal found. Bull markets for bonds lasted 48 months on average and produced gains of 60.4 per cent.
