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Should you bypass bonds while waiting for interest rates to rise?

Investors seem way more stressed about bonds than stocks these days.

Readers of the Carrick on Money newsletter regularly ask questions these days about why bonds and bond funds have been falling in price, and whether it’s worth holding these investments at all when interest rates are in an up-trend. Rising rates depress bond prices, while falling rates send bonds higher.

Here’s a sample question from a reader who recently moved money from a mutual fund company to an online brokerage account where he’s invested in exchange traded funds covering Canadian, U.S. and international stock markets and, to a limited extent, bonds. “I still have about one-third of my portfolio in cash,” he wrote. “With rising interest rates would It be safer to stay out of bond ETFs and maintain my cash positions for now?

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Holding cash in a brokerage account is certainly safe, but the returns are weak. Investment savings accounts – basically high interest savings accounts that trade like a mutual fund – offer 1.1 to 1.15 per cent these days. The cost of living rose 2.2 per cent in February, which means holding cash is a losing proposition on an after-inflation basis.

You can get an average 2.7-per-cent yield by building a five-year ladder of guaranteed investment certificates offered by lesser known banks (all members of Canada Deposit Insurance Corp.) and sold through online brokerage firms. The GIC ladder is a poor choice if you think you might need to sell before maturity. But if you’re comfortable buying and holding, the ladder protects you against price volatility in the bond market and gives you money coming due every year to take advantage of rising interest rates. If rates end up falling, the ladder limits your exposure.

Bond ETFs are fine to hold through a period of rising rates if you need regular interest income and are willing to overlook price declines ahead. When rates eventually peak and head lower, bond ETFs will rise in price. A GIC ladder is a more stable alternative with a decent yield by today’s standards that beats cash hands-down. If you’re stressed about bonds, consider the GIC ladder.

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