You're in a vise, investors.
On one side, the bonds you've been buying for safety are showing their nasty side this month by falling sharply in value. On the other, September, one of the worst months for the stock markets on average, is almost here. If stocks plunge, you want bonds in your portfolio.
To own bonds, or not to own bonds. That is the question misguided investors ask themselves at times like this. They think in absolutes – dump bonds and buy stocks to take advantage of an improving economy; or, dump stocks and buy bonds to protect against a new recession. What, they ask, is the winning strategy?
Actually, there isn't one. The way to loosen the vise is to cover all eventualities by diversifying your bond holdings. You won't score a decisive win that way, but neither will you lose in a major way.
The recent fall in bond prices can be seen in month-to-date losses in the range of 1 per cent on average for the typical big bond mutual fund for the year through Aug. 17. The benchmark for the Canadian bond market, the DEX Universe Bond Index, is down 1.2 per cent.
Basically, what's happening is that investors are having second thoughts about parking money in government bonds that yield a miserably low 1 to 2 per cent.
"A huge amount of safe-haven money has gone into risk-free investments – U.S. Treasury bonds, Swiss franc bonds, German bonds, Canadian bonds," said David Fry, CEO of Lawrence Park Capital Partners. "The view is, 'the world's not a very safe place and I'm going to take nothing [in returns] to protect my money.'"
Mr. Fry said concerns about risk have eased lately, possibly as a result of developments in Europe that suggest the debt problems in various countries won't lead to the demise of the euro as a common currency.
Global investors shift their views on risk as often as we civilians change TV channels. So it may well be that you'll wake up tomorrow to news that bonds are in fashion again. Ignore that and stick with a bond diversification plan that works no matter what happens.
Bonds have performed very well over the past five years – certainly better than stocks. But Mr. Fry said investors may not be getting as much from their bonds as they think they are. He lists three reasons to own bonds – to preserve capital, to lower the intensity of the stock market's ups and downs and to generate income. "If they did a review right now, a lot of people would struggle to find that they're achieving any of these goals."
Check it out – bond funds are losing money this month, they're showing some volatility and, as for income, they're paying precious little.
Mr. Fry's suggestion is to start with whatever proportion of bonds works for your risk profile and investing needs, and then mix it up. Half might go into government bonds, which have fallen the most this month and will sink lower if and when interest rates make a sustained move higher.
Government bonds are, in Mr. Fry's words, "disaster protection." If the global economy weakens and interest rates fall from their already low levels, they'll do well. Same goes if a global financial crisis is triggered by Europe's debt problems. Remember: Canadian bond funds made almost 3 per cent on average in 2008, while Canadian equity funds lost an average 34 per cent.
The rest of your bond holdings might go into corporate bonds, which are theoretically more risky than government bonds. A government can always increase taxes to meet its bond obligations, whereas a corporation must generate enough revenue through its operations. But, in yet another sign of how mixed up things are in the financial world, many corporations are now in better shape than governments.
Lawrence Park's Credit Strategies Fund, available to high net worth people, invests in corporate bonds while betting on a decline in government bonds through short selling. Don't try this at home. Instead, figure out your total exposure to bonds, and then the breakdown of government and corporate bonds (look to mutual fund company websites for this info). You might also add a small bit of high-yield bonds, issued by non-blue chip companies that pay higher yields.
Make sure you've got a good mix of bonds, and that you're not over– or underweighting bonds in your portfolio. That's how you keep from getting crushed in the vise.
Bonds get beat up
A quick tally of how bonds have performed for the month through Aug. 17. Note that while corporate bonds have fallen, the decline has been less than with government bonds.
Dex Universe Bond Index: -1.15 per cent
DEX Universe All Government Bond Index: -1.29 per cent
DEX Universe All Corporate Bond Index: -0.77 per cent
Source: PC Bond Analysis