Getting uncomfortable with bonds? Hang tough

Do the right thing: Own bonds.

Even with interest rates expected to rise this year and next?

Of course. Sensible portfolio construction is based on your personal needs and risk tolerance, not interest rate forecasts. You don't have to be a passive victim of rising rates, though. There are several measures you can take to help the bond side of your portfolio survive rising rates with a minimum of damage.

First, a quick review of bond market basics. The price of bonds and bond funds goes down when interest rates rise, and vice versa. If you own individual bonds, you'll see some price decreases in your account statements that will distract you from the fact that you'll still get your money back when the bonds mature. If you own bond mutual funds or exchange-traded funds, then price decreases can only be reversed when interest rates fall again.

There are rate increase skeptics out there who think the economy won't soon recover to a level where higher borrowing costs are needed to stave off inflation. In that case, there's an argument for avoiding bonds because the returns of the moment are so low. But either way - rising rates or steady rates - you need bonds.

"We recommend having a portion of a portfolio in bonds, even if they're not expected to do well," said Warren MacKenzie, president of the advisory firm Weigh House Investor Services. "You have to protect your capital, and bonds will do better than the stock market if we have another downturn."

There are questions about when interest rates will move higher, but it's a done deal they will rise at some point from today's historically low levels. Let's look at how to get your portfolio ready.

François Bourdon, manager of the Horizons AlphaPro Fiera Tactical Bond Fund, has been preparing for higher rates by moving into shorter-term bonds. A key rule for bonds in a rising rate world: Short term bonds hold up better than long term bonds. Put a little more bluntly, they will fall less in price.

Mr. Bourdon said the average duration of his portfolio - that's the time required for the bonds to repay the cost of buying them - has been shortened to four or 4.5 years over the past six months from six years.

"The idea is that as interest rates move up, we will not suffer as much," Mr. Bourdon said.

If you're investing in bond mutual funds, you can find the duration using the Morningstar.ca website (see chart). For bond exchange-traded funds, consult ETF company websites. Mr. Bourdon said a good rule of thumb for duration in a time of rising rates is to keep it between three and five years.

With an average weighted duration of three years, a one-percentage-point increase in rates would cause a bond fund to fall three percentage points in value. However, the interest payments from the fund would likely offset that loss and leave you flat. "If this happens in a good economic environment, your stocks will make up for it," Mr. Bourdon said.

Horizons AlphaPro Fiera Tactical Bond (HAF.UN-TSX) is a closed-end fund with about 40 per cent of its assets invested in corporate bonds through an ETF called the iShares CDN Corporate Bond Index Fund (XCB-TSX). Closed-end funds and exchange-traded funds both trade like stocks - they differ in that the former employs a manager to pick bonds or stocks while the latter is primarily a tool for tracking stock and bond indexes.

Government bonds are the most vulnerable to rising rates, but Mr. Bourdon said corporate bonds will fall in price, too. That's why he'll be paring down his exposure to them to something like 35 per cent of the portfolio and putting the proceeds into a short-term bond ETF called the iShares CDN Short Bond Index Fund (XSB-TSX).

Why keep such a big portion in the corporate bond ETF? Mr. Bourdon explains that corporate bonds offer higher yields than government bonds (with more risk), the duration of XCB is reasonable at 5.3 years and the holdings are diversified across 348 different bond issues. Also, the outlook for corporate bonds is tied in part to the health of the economy, and rising rates suggest a robust level of health.

Mr. Bourdon also plans to reduce his holdings in an NYSE-listed ETF that holds high-yield bonds - the iShares iBoxx $ High Yield Corporate Bond Fund (HYG). The outlook for high-yield bonds is even more tied to the economy than corporate bonds, so rising rates aren't the issue here. Rather, it's that high-yield bonds have surged in price over the past year and warrant some profit-taking.

Views on holding corporate bonds differ widely among advisers. Weigh House's Mr. MacKenzie thinks high-quality corporate bonds should account for about 25 per cent of an investor's overall bond holdings. He estimates the benefit to be an extra 0.5 to one percentage point of yield.

Calgary-based investment adviser Kevin Cork avoids corporate bonds and their riskier but higher-paying cousins, high-yield bonds. "The returns on them can be tremendous," he said. "But for a lot of people, they require an extra layer of understanding and risk tolerance."

For an investor with a 50-50 split between stocks and bonds, Mr. Cork said he'd put 30 per cent of the bond holdings in a diversified bond mutual fund, 10 per cent in a money market fund and the final 10 per cent in a real-return bond fund.

The diversified bond fund is all about having an investing professional navigate the rate landscape for you, the money market fund is about keeping money safe (at the expense of returns) and the real return bond fund is to provide portfolio protection if inflation jumps. For "extra nervous" clients, Mr. Cork might use a short-term bond fund or a mortgage fund instead of a regular bond fund.

An alternative to short-term bond funds is to build a ladder of bonds or guaranteed investment certificates. That means equally dividing your investments into GICs with maturities of one through five years. Last week's Portfolio Strategy was all about using GICs as a replacement for bond funds, and you can read it at http://tgam.ca/GfP.

Warning: Rising rates will make it uncomfortable to own bonds and bond funds. So prepare as best you can and remember that not having bonds puts you first in line to get hit if the stock market blows up again.

Playing defence with bonds

With an eye toward rising interest rates, we asked a couple of investment advisers how they would structure the bond side of a client's portfolio. The target investor here is someone who is reasonably conservative and has a portfolio evenly split between stocks and bonds.

Gauging the downside risk of bond funds Look for the weighted average duration of your fund, which is the time needed to recoup the cost of buying the bonds in the fund's portfolio. Here's how to find out about duration:

Bond mutual funds:

• Go to: morningstar.ca/globalhome/industry/FundCompare.asp

• Add the funds you want to research

• Click where it says "Show Comparison"

• Select the "Portfolio" view from the pulldown menu

Bond exchange-traded funds:

• Go to ishares.ca, claymoreinvestments.ca, bmoetfs.com or hapetfs.com

• Look up bond ETF profiles to find duration information

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