The bond advantage in a weak economy

Even amid rising stock markets and stunted interest rates, there's a case to own bonds.

Argument No. 1: Bonds are an insurance policy against the possibility that the stock markets fall hard again after jumping ahead more than 50 per cent from their bear market lows.

Argument No. 2: Bonds may actually produce modestly decent returns if it becomes clear the economy is further from a rebound than people imagine.

For sure, bond yields are just ridiculous now. Five-year Government of Canada bonds yield about 2.5 per cent and rates fall all the way to 0.5 per cent for something that matures in a year. Think of these low returns as the price you pay for protection.

"If there was one lesson people should have learned in the financial crisis, it's that you have to put some money aside to absorb risks," said Sheldon Dong, vice-president of fixed-income strategy in the portfolio advice and investment research area of TD Waterhouse.

"You're not buying bonds to get rich," Mr. Dong added. "In my mind, you're buying them for capital preservation. The yield is secondary."

They don't come much more conservative than Mr. Dong in the investment industry. He thinks a 60-40 mix of stocks and bonds, respectively, is too risky for many people and he says the right allotment of bonds comes down this question, "how much money can you afford to lose?"

His risk aversion further dictates that investors buy bonds maturing in no more than five years. Eventually, he said, the economy will recover and interest rates will move higher. Bonds of all maturities will fall in price when that happens, but longer-term bonds will be hit the hardest.

Enough money flowed into bonds at the height of the financial crisis that we started to hear the term bond bubble being used. But Mr. Dong said falling bond prices are only a concern to the minority of investors who trade their bonds (buy and then sell before they mature). If you hold until maturity, fluctuating bond prices are just a distraction from the fact that you'll get the full face value of the bond back on maturity.

Mr. Dong prefers individual bonds held until maturity to bond funds, and the reason has to do with costs. Retail investors may not realize it, but sizable commissions are built into the price they're quoted when they buy bonds. The higher the price paid for a bond, the lower the yield (and vice versa, of course). Bond funds, meanwhile, charge management fees that are lopped off returns before they're reported to investors.

Buying Guide for Bonds

"In the long run," Mr. Dong said, "it's much cheaper to pay a one-time commission than paying management fees."

The best bond values to him are provincial bonds and bonds issued by the big banks, all of which offer higher yields than federal government bonds. Of course, bonds issued by Ottawa are the safest.

At worst, bonds are a safe but largely inert portfolio building block in today's market. At best, you may actually make some money with them.

The deciding factor here is the economy - is it on the mend and thus likely to trigger interest rate increases in the next year or so, or is it fragile enough to be reliant on government stimulus?

Robert (Hap) Sneddon, president of portfolio managers CastleMoore Inc., believes the economy is shakier than most people think. What's more, he thinks this is already being reflected in the bond market.

It's typical when the economy starts to emerge from recession for bonds and stocks to both rise, he argues. Eventually, though, bonds peel off while stocks continue to do well. We're now at a point where bonds would normally have started to falter, but this hasn't happened. In fact, bonds have been strong lately. To Mr. Sneddon, the message here is economic weakness ahead.

This view is influenced by the example of the last recession and bear market. Stocks began to fall in 2000 and then rallied in mid-2001 amid signs of an economic recovery. What happened next was a renewal of concerns about the economy and a 33-per-cent decline in share prices.

Mr. Sneddon said one reason to believe that history could repeat is that U.S. consumers, the engine that drives 70 per cent of economic output, have drastically curbed their spending lately. Consumers were expected to pay down debts by $4.5-billion (U.S.) in June, but they in fact paid down $21.6-billion.

Canadians are also riding the savings wave. By one estimate, there's $60-billion (Canadian) more in bank deposits today than you'd expect under typical conditions.

The problem with intensive saving was described by the economist John Maynard Keynes as the paradox of thrift. In embracing the virtue of thrift and not spending, people choke off economic growth.

Mr. Sneddon believes this frugality theme will keep interest rates lower than people think, and for longer. This is what the bond market is saying, even as the stock market surges.

"There's an adage that the bond market is a little smarter than the stock market," he said.

Mr. Sneddon's suggested approach for capitalizing on his economic outlook: Buy the long-term bonds that Mr. Dong sees as being too risky.

While short-term interest rates are close to zero, long-term rates have room to fall further. If they do, then investors holding long-term bonds will be in a position to make some capital gains on their bonds.

In other words, long-term bonds right now are more about a trading opportunity than about yield.

Bonds with terms of at least 10 years are what Mr. Sneddon has been buying lately. For investors who prefer using funds as opposed to buying individual bonds, he suggested the iShares CDN Long Bond Index Fund. It's an exchange-traded fund, or ETF, which means you'll need a brokerage account to buy it.

The yield on this ETF is a comparatively strong 4.3 per cent, but not many investors are contrarian enough these days to buy in. Of the six bond ETFs in the iShares family, CDN Long Bond has been generating the lowest daily trading volumes lately.

Mr. Sneddon said a less volatile choice would be the much more popular iShares CDN Bond Index Fund , which covers the entire bond market rather than just focusing on long bonds. For exposure to U.S. long-term bonds, he uses the iShares Barclays 20+ Year Treasury Bond Fund.

Since the bottom of the bear market in March, stocks, commodities and bonds have all done well. Check the potential down side for all three and you'll find the case for bonds made quite nicely.