While everyone wonders how much longer the stock market can rise without a correction, bonds have mounted an insurrection of their own. Those treacherous bonds. They were bought in great quantities in the past couple of years by investors seeking safety, stability and good returns as well. Now, bonds are falling in value.
We have no way of knowing whether bonds will keep falling, or rebound as they've done a few times in recent years after pullbacks like we're now seeing. What we do know is that a heck of a lot of money went into bond funds over the past two years, and the investors who own them need to understand the risks.
"Clients are not attuned to much volatility in the bond market because interest rates have been coming down for the last 25 years," said Sheldon Dong, fixed income strategist at TD Wealth. A key bond basic: Bonds and bond funds rise in price when rates fall, and they decline when rates move higher.
For more on bonds and rising rates, here is Portfolio Strategy's four-step bond fund risk diagnostic guide.
Step 1: Understand the problem
The bond market decline in the past month or so has been severe, and so has the pullback by widely held bond funds and ETFs. Most of the largest bond mutual funds and ETFs had losses over the past 30 days of 0.8 to 1.8 per cent. In the context of the 1.56-per-cent yield on five-year Government of Canada bonds, that's a sizable drop for such a short period of time (bond yields rise as prices fall, and vice versa).
We've seen bonds fall sharply before in the past few years, only to come back stronger as a result of continued bad news on the economy. But there's growing optimism that economic conditions are improving and thus clearing the way for a sustained move higher in interest rates. Consider the gain of 95,000 jobs in May, Canada's biggest monthly jump in almost 11 years.
We don't measure the bond market by price changes, as we do with stocks. Instead, the focus is on bond yields. The five-year Canada bond yield has risen about 0.4 of a percentage point since May 1, which is an usually sharp move. Further yield increases would likely be more gradual.
Step 2: Understand how different types of bonds react to rising rates.
Prepare yourself for yet another lesson on how risk levels increase as you strive for higher yields. One of the safest types of bond fund in May was the short-term bond fund, which also has the lowest yields.
Higher payouts are available from long-term bond funds, which were hit quite hard in May. Sill higher yields come from high-yield and emerging markets bonds, both of which were also slammed. The more you strive for higher returns from the bonds in your portfolio, the more risk there is that you'll lose money.
Real return bonds deserve special attention here because they fared so badly in May. Real return bonds are used to protect against inflation, which isn't much of a concern right now. As a result, real return bonds are being treated like the long-term bonds they actually are. Real return bonds held in exchange-traded funds focusing on this sector mature, on average, over the next 10 to 30 years or more.
Conversely, floating rate bonds are attractive when rates move higher because they regularly reset their interest payouts to reflect current bond market conditions. Note that the Horizons Active Floating Rate Bond ETF, listed in the accompanying chart, does not actually hold floating rate bonds. Instead, it uses derivatives to achieve a floating-rate effect from a portfolio of conventional short-term corporate bonds.
Step 3: Understand duration
Duration is a definitive measure of bond fund risk. It refers to the number of years it takes to recoup the cost of buying a bond from semi-annual interest payments and repayment of capital on maturity. For bond funds, refer to the weighted average duration. The higher a fund's duration, the more risk there is.
But we can get even more specific by saying that whatever a fund's duration, that's how many percentage points it will drop if interest rates, as gauged by bond yields, rise by one percentage point (the opposite is true for falling rates). For example, a good all-purpose bond option is the Vanguard Canadian Aggregate Bond Index ETF, with a weighted average duration of 7.2. If rates rise one point, this fund could fall 7.2 per cent.
You can find duration data for ETFs on the issuing company's website. For bond mutual funds, go to a fund company's website and look for the most recent profile or portfolio update. Or, try a Google search along the lines of "Acme Bond Fund duration."
Looking at duration underscores the safety of short-term bond funds. In the accompanying chart, the least scarred bond ETF in May was the iShares DEX Short Term Bond Index Fund, with a duration of 2.8 years. Much harder hit was the PowerShares Ultra DLUX Long Term Government Bond Index ETF, with a duration of 14.5 years.
One caveat: Duration isn't that helpful in assessing the risk in high yield and emerging markets bonds. The iShares U.S. High Yield Bond Index Fund has a comparatively low duration of 4.2 per cent, but still fell hard last month.
Step 4: Understand the differences between individual bonds, bond funds and guaranteed investment certificates.
Bond fund prices move in the opposite direction of interest rates – they fall when rates are rising and rise when rates decline. With the exception of a fairly obscure category called the target date bond ETF, there is no maturity date where your original investment is handed back to you.
Individual bonds give you that maturity date, although investors may not get back exactly what they paid for their bonds. That's because many bonds today sell with a price premium over their issue price. When they're redeemed, it will be at the issue price.
GICs are a big problem-solver for investors worried about holding bonds in a rising rate world. GICs aren't easily sold before maturity unless you buy a cashable version (which will mean a sacrifice in yield). But they can provide higher yields than government and many high quality corporate bonds, with the additional benefit of deposit insurance from either the federal Canada Deposit Insurance Corp. or credit union plans that vary from province to province. "I like GICs in a rising rate environment," said TD's Mr. Dong. "They preserve your capital."