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In this Jan. 14, 2014 file photo, oil pumps work in the Persian Gulf desert oil field of Sakhir, Bahrain. In the second half of 2014, oil prices dropped by half.

Hasan Jamali/The Associated Press

The back-door way to benefit from falling oil prices is to buy bonds.

The recent plunge in oil prices has so degraded the economic outlook that the Bank of Canada has cut its benchmark lending rate by a quarter-point last week. Bond yields have been falling as well, which means bonds and bond funds are off to a great start to 2015. As of Jan. 27, a wide swathe of bond exchange-traded funds had outperformed the S&P/TSX composite index.

With the Government of Canada five-year bond yield down to a puny 0.8 per cent in late January, investors looking ahead have every reason to question the sense of holding a significant bond weighting in a portfolio. As ever, the main reason is to hedge against a stock market decline. But bonds also act as a hedge against the kind of bad economic news we've had so far in 2015.

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A year ago, the five-year Canada bond had a yield around 1.6 per cent. The decline in yield since then has generated capital gains for bonds of all maturities – both long and short. Of course, long bonds have benefited most. But more conservative short-term government bonds have done fine, as well. The iShares 1-5 Year Laddered Government Bond Index ETF (CLF-T) had a year-to-date gain of 1.2 per cent as of Jan. 22, while the S&P/TSX composite gained 1 per cent. The longer duration of the iShares Canadian Government Bond Index ETF (XGB-T) produced a year-to-date gain of 3.1 per cent, while the BMO Long Federal Bond Index ETF (ZFL-T) gained 5.3 per cent.

Economic uncertainty is more of a factor for Canadian investors now than at any time in the past five years. We know that low oil prices are good for consumers and help manufacturers by putting downward pressure on the dollar. But the Bank of Canada rate cut suggests a serious level of concern about the downside risk to growth. In other words, things could get worse.

Bonds are a hedge against unexpectedly bad economic news. Remember this if you can't see any more room for bond yields to fall: People have been calling a bottom for bond yields for five years now, and yields keep getting lower.

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