For the last several years, investors have shifted many billions of dollars from equity-based investment products, to the perceived safety of bonds and bond funds.
Primarily, these decisions have been based on perfect hindsight — over the past five years, bond-based investments have returned about six per cent annually, while equities have on average, returned less than one per cent.
Correct as this historical comparison may be, it is not a sound strategy upon which to base a decision to jump from equities into bonds.
Investors should consider the root cause of bond markets outperforming equities in recent years.
Yields of bonds and bond funds have actually shrunk during their bullish run.
However, as is normal, when interest rates fell, the capital value of bond holdings rose — hence the robust performance.
Since bond values move in the opposite direction to interest rates, it is important for potential bond sector investors to consider the likely direction of such rates as we look to the future.
Rates are currently at 50-year lows. Since there is virtually no room for further downward movement, there is little likelihood of further capital appreciation for this sector.
We can be certain however, that interest rates will rise. It is only a matter of when, and by how much.
As soon as rates increase, the bond sector will come under downward price pressure. Again like lemmings, investors will this time begin to flee the bond sector and move back to equities — thus reversing the recent trend.
Those who have moved into bond-based holdings are faced with potential value-erosion as rates rise; the longer the maturities of their bond holdings, the greater the risk.
This is not to suggest that holdings in the bond sector do not have a place in many portfolios. But such holdings should be of short-term duration.
An ideal option could be a one-to-five-year laddered government and/or corporate bond holding. With an average term to maturity of only two-and-a-half years and the ability to increase yields as interest rates rise, capital values are well protected.
Several exchange-traded funds offer this option at very low cost.
It is also worth noting that had an investor held dividend-paying equities over the past five years, his average annual return would have been comparable to the bond-based holdings.
Furthermore, for non-registered accounts, the dividend yields from equities would have been far more tax-effective than the highly-taxed bond interest payments.
Whenever contemplating a move, be it in or out of a particular sector or individual holding, past performance truly does not reflect assurance of future performance.
It is important to not rush precipitously into action.
An investor must make investment decisions based on current and future circumstances, and not solely on past performance.
A retired corporate executive, enjoying post-retirement as a financial consultant, Peter Dolezal is the author of three books. His most recent book, The Smart Canadian Wealth Builder, is available at Tanner’s Books and in other bookstores.