PETER DOLEZAL: Bonds as risk moderators

Or not? Traditionally, bonds and bond funds in an investment portfolio have been considered reliable moderators of market risk.

Traditionally, bonds and bond funds in an investment portfolio have been considered reliable moderators of market risk. Is that still the case?

Over the past 60 or so years, stock markets enjoyed a dozen long stretches of Bull markets and a similar number of shorter-duration Bear markets. Investors could always rely on their bond holdings to temper volatility in equities — especially during negative markets.

Why were bonds so reliable in moderating the effect of stock market declines? This stemmed from the fact that bond values always move in the reverse direction to interest rates. When rates rise, bond value decline. When interest rates decrease, bond values increase.

Historically, a Bear equity market occurred because an economy was either entering recession, or already in one. In response, the Central Bank moved to reduce interest rates, thus creating a stimulative effect on the economy. This slowed the economy’s decline, eventually reversing itself when interest rates dropped sufficiently. As rates fell, investors holding bond products with assured coupon interest higher than market, would see their bonds rise in value. That increase in bond values would offset at least a portion of the decline in equity holdings.

Since this moderating effect of bonds proved itself over many decades, investors were often advised to hold bonds or bond funds in their portfolios. The only real question was how to apportion holdings between equities and bond holdings. Of course, when market rates increased, bond values declined, and investor gains in equity investments again were moderated, but in this case equity gains were partly offset. This was considered a worthwhile price to pay for the protection of overall portfolio values when equity markets declined. Investors could sleep easier knowing their portfolio value would always decrease by a smaller percentage than a periodic decline in equity markets.

Unfortunately, this historical moderating effect of bond holdings on portfolios can no longer be considered a sure thing.

In past decades, Central Banks always had the option of increasing or decreasing rates. However those rates were always at significant levels — often between four and seven per cent.

Today, Central Banks in every developed nation, including Canada, have cut interest rates to near zero. Hence, the predominant direction of future rates can only be upward.

When interest rates do increase, as they will, bond values will decline. Looking forward, the traditional safety net offered by bond holdings has been substantially eliminated.

Does this mean investors should avoid bond holdings altogether? Not really, but they must be aware that the level of risk moderation they previously enjoyed is now much reduced. If an investor holds individual bonds rather than bond funds, he will receive the coupon interest payments and, if the issuer of the bond stays in business, as the bonds reach their maturity date, receive the original issue value (usually $100 per bond). However, this will not have protected the bond during its term from value-fluctuations in response to interest rate changes. Despite this positive outcome at maturity, holding individual bonds severely limits the degree of diversification — and hence safety — that is available with much more diversified bond funds. On the other hand, since bond funds, unlike individual bonds, have no maturity date, no guaranteed payout value is available.

So what are today’s options for the Fixed Income component of a portfolio? Holding Cash or Money Market funds would generate virtually zero income, nor provide an opportunity for appreciation. GICs would fare a bit better but, with low yields and no capital appreciation, fail to match inflation. Individual bonds would fare better but represent higher risk due to limited diversification.

A credible option might be a one to five-year, low-cost, laddered Exchange-Traded (ETF) Corporate Bond Fund. This would produce around three per cent in annual yield, with limited downward pressure on capital values as interest rates increase. A solution could also include a carefully-selected Laddered Preferred Share Fund.

With most fixed income investments no longer delivering the automatic hedge against falling equity values, it becomes even more important to exercise great care in the choices made, both within the fixed income, as well as in the equity components of one’s portfolio.

 

A retired corporate executive, enjoying post-retirement as an independent Financial Consultant (www.dolezalconsultants.ca), Peter Dolezal is the author of three books, including his most recent, The Smart Canadian Wealth Builder.