Doing the right thing as an investor can sometimes be costly and painful. Example: Holding bonds when interest rates are rising.
Bonds are a non-negotiable part of a well-diversified portfolio, but they're struggling right now. Count on this continuing as long as there's an expectation of high rates in Canada.
Here's a seven-point survival guide for bond investors in our new rising-rate world.
1. Remember why you own bonds
Bonds are a hedge against two big risks to your portfolio – a stock market crash and an economic downturn. At times of uncertainty, money flows out of stocks and into bonds.
Over the 10 years to June 30, the benchmark FTSE TMX bond universe index produced an average annual return of 5.1 per cent.
You probably made less in your bond mutual fund and exchange-traded funds as a result of fees, but bonds still produced a decent return.
Bonds and bond funds have already started to fall in price and you can expect this trend to continue if rates keep edging higher. Don't abandon your bond holdings – adjust them. The hedge against disaster they provide is as important today as ever.
2. Duration is key
Duration is how you measure the extent to which a bond is affected by changes in interest rates.
If rates rise by one percentage point, the price of a bond or bond fund with a duration of five years would fall five percentage points (and vice versa if rates fell). The higher the duration, the more risk there is if rates rise.
The fund profiles that issuers of bond ETFs provide online show you the duration for the portfolios these funds hold. Some mutual-fund companies include duration in the information they post online about their funds. A quick review of online brokers found that many don't show duration for individual bonds listed for sale.
One exception was TD Direct Investing, which includes duration in the online information page you see when reviewing a particular bond in the firm's inventory.
The lowest duration risk is in short-term bonds. Diversified bond funds have somewhat more duration risk because they mix short and longer-term issues, while long-term bonds are the riskiest.
3. Yields for individual bonds are still awfully low
Wondering how much of a yield boost you can expect based on recent events if you were to buy some bonds or bond funds right now? The yield on the five-year Government of Canada bond is a useful gauge of what's happening in the bond market. Since the end of May, the yield on this bond has soared to 1.5 per cent from 0.94 per cent.
That's a huge increase by bond market standards, but it still leaves yields at low levels on a historical basis. A scan of online brokerage bond inventories this week suggests that five-year provincial bonds might get you a yield of a bit over 2 per cent, while a blue-chip corporate bond might get you something in the midpoint between 2 per cent and 3 per cent. A corporate bond rated BBB – that's the low end of investment grade – might get you to 3 per cent or a bit more over five years.
The largest diversified bond ETFs offer yields between 2 per cent and 2.2 per cent these days – that's their yield to maturity minus fees.
4. Corporate bonds are a good place to be
Investor sentiment favours corporate bonds over government bonds right now. Rising rates mean a healthier economy, which makes corporations financially stronger and better able to repay what they borrow through their bond issues.
The FTSE TMX Canada all government bond index was down 0.9 per cent for the 12 months to June 30, while a related index tracking corporate bonds was up 2.6 per cent. Yes, government bonds typically have higher credit ratings and are thus less likely to default on interest and repayment of principal. But if interest rates keep moving higher, expect corporate bonds to outperform. If rates rise sharply, this could mean losing less money than government bonds.
If you own a broadly based bond fund or ETF, you already have a mix of government and corporate bonds. You can add a corporate bond fund to bulk up your exposure to this sector, but don't forget that government bonds are what investors will want if there's a shock in financial markets.
5. Consider the GIC ladder
Guaranteed investment certificates offer better rates than government and most blue-chip corporate bonds, with comparable security. GIC issuers are either members of Canada Deposit Insurance Corp. or provincial credit union deposit insurance plans.
GICs are illiquid securities, which means there's no easy way to sell them before maturity. If you do manage to sell in mid-term, expect to pay a stiff penalty. On the plus side, GICs don't rise and fall in value in your investment account like bonds and stocks.
Laddering – it works for GICs and bonds – means dividing your money evenly into deposits maturing one through three years and then investing maturing money into a new three-year term. You can also try a five-year ladder, but there's not much premium these days for locking down money for five years rather than three.
6. Home Capital rules on GIC rates
Late this week, DIY investors were able to get 2.75 per cent for one-year GICs, 3.05 per cent for a three-year term and 3.25 per cent for five years from Oaken Financial, which is part of Home Capital Group, the alternative mortgage lender. No one even comes close to these rates in the GIC market right now.
Higher rates mean higher risk. Deposits at Oaken are covered by Canada Deposit Insurance Corp. to a maximum of $100,000 in combined principal and interest for eligible accounts, but there's an emotional side to consider as well. Will you be eaten up by stress if once-troubled Home Capital stumbles again? Do you invest in GICs for a strict zero-stress experience? If so, the extra yield is not worth it.
If you have an adviser, check out the rates at Home Trust and Home Bank. Both divisions of Home Capital have lower rates than Oaken, but still beat most other GIC issuers. They're both CDIC members.
7. Floating-rate bond funds are holding up well
Floating-rate bonds are considered a defensive play because they adjust their interest payments in line with fluctuations in interest rates. The duration for these bonds is typically less than one year, which makes them more stable than even short-term bond funds. There are a few floating-rate bond ETFs and they've held up comparatively well in recent weeks, though yields are low. Among the ETF companies offering these funds are BMO, Horizons, iShares, PowerShares and Mackenzie.