Stocks are the ties that bind you to bonds.
Yes, it's true that bonds have low yields. It's also true that bonds are headed for a crew cut when interest rates rise. In the eyes of many people, the stock markets are clearly the place to be just now.
But while these objections to having a full commitment to bonds today are all valid, they ignore a key point about building portfolios the right way. Stocks are unpredictable and the only sound way for most investors to manage the volatility is to keep bonds in their portfolio.
"For most of the time in the past 13 years or so, bonds have been negatively correlated to stocks," explains Michael Herring, managing director and investment strategist at BMO Nesbitt Burns. "When stocks are down, bonds are up. So they provide a nice diversification effect, a counterbalance that dampens the volatility of the overall portfolio."
The upshot? Bonds are essential, but right now they look like a loser's investment. Deal with it by following our Bond Survival Guide.
Let's start with the right mix of stocks and bonds. For what he describes as a balanced portfolio, Mr. Herring suggests a blend of 35 per cent bonds and 65 per cent stocks. That's a rough guideline, of course. You can adjust it according to how aggressive or conservative you are.
Once you find the right mix for your needs, resist the temptation to lighten up on bonds because of the current market outlook. Instead, think short term.
Short-term bonds mature in five years or less, mid-term bonds run up to 10 years and long-term bonds mature in 10 years or more. You get more interest with long-term bonds, but they're the most likely to cause you problems when interest rates rise. So stick with bonds maturing in one to five years, Mr. Herring said.
Mutual Funds, ETFs
One option is to invest in mutual funds and exchange-traded funds specializing in short-term bonds. Or, you can buy individual bonds or guaranteed investment certificates and use the tried-and-true laddering approach. That's where you divide your money equally into bonds maturing in one through five years. As a bond matures, you reinvest in a new five-year term.
Your returns will be low if you do this - maybe 1.5 to 2.5 per cent on a blended basis. But your portfolio will also be much more resistant to rising interest rates. Mr. Herring calculates that a five-year bond ladder would be only 40 per cent as sensitive to rising rates as the overall bond market.
Bonds maturing in 10 years or more present the biggest risk of jarring price declines. Let's be clear here - bonds don't stop paying interest when rates rise, but they do fall in price. Actual bonds will repay your upfront investment back at maturity, while bond funds and ETFs will rebound in price as interest rates fall in the future.
Still, even if you're holding a bond until maturity, the potential price declines over the short term can sting.
How It Works
Some background: As bond yields rise, bond prices fall. If the yield on a 30-year Government of Canada bond were to move up by a full percentage point, the bond's price would drop 18 per cent, according to Mr. Herring. Even if you're holding to maturity, that's quite a hole to see punched in your portfolio when your monthly statement arrives.
On the other hand, if you've got new money to invest in bonds, higher rates will be welcome. The annual maintenance of your bond ladder will help in this regard. "You'll be given opportunities to invest at successively higher yields," Mr. Herring said.
A lot of investors have been improving a bit on the low yields of government bonds by branching into bonds issued by financially strong companies. Mr. Herring said his firm believes both kinds of bonds are fully valued, which is to say they have room to fall in price as rates rise. At best, you'll likely just get the interest paid on these bonds. The capital gains that investors have seen from bonds as interest rates fell are likely a thing of the past.
High-yield bonds, issued by less financially strong companies, may have a little room left to rise in price, Mr. Herring said. These bonds offer much higher yields than blue-chip companies and governments, but much more risk if the economy struggles. In fact, the risk profile of high-yield bonds is closer to stocks than that of government bonds.
While it's essential to hold some bonds in your portfolio as a buffer against the stock markets, many investors have gone overboard since the 2008 market crash. Mr. Herring's take on the right mix of stocks and bonds for today's market? "We're advocating a balanced investor hold fewer bonds than they hold stocks."
How To Handle Bonds
1. Determine your appropriate asset mix of stocks and bonds and stick to it.
2. Use a five-year bond ladder, in which you stagger your holdings in bonds or GICs.
3. Avoid long-term bonds.
4. Recognize that both corporate and government bonds are fully valued now and vulnerable to price declines when interest rates rise.
5. Remember the rationale for bonds: They tend to go up when stocks go down.