Risks emerge as bond values decline predicted

As interest rates rise eventually, bond values are expected to drop

Bonds and bond funds have long been the cornerstone investments of the fixed-income portion of Canadians’ investment portfolios. For several decades, bond holdings have delivered reliable returns – with very few years showing negative results. Over the past decade in particular, bond holdings on average have annually outperformed equities by several percentage points.

So why worry? Will this stellar performance not continue into the future? To answer these questions, we must first understand the reason for the bond sector’s most recent superior performance.

Over the past decade, interest rates have steadily and dramatically declined. Today, they sit at historic lows. Since bond values move in the opposite direction to interest rates, their capital values have increased. When added to the annual interest paid, this substantial increase in value has greatly enhanced the bond investor’s total annual return.

Looking forward, the emerging risk to bond holdings is the absolute certainty that interest rates will rise. The only question is when and how significantly. As interest rates increase, bond values will decline; those with longer-term maturities will suffer the most.

If an investor holds high-quality individual bonds to their maturity, he should, regardless of intervening rate increases, recover all invested capital. However, should the bonds be sold prior to maturity, a significant capital loss could be the result. Bond funds, comprised of many individual bonds, each with a different term, may, since they do not have a fixed maturity date, present even greater risk.

Should we then retreat from such investments over the next decade? Not at all. But we must be mindful not only of the emerging risk, but also take steps to minimize it.

Buying individual bonds and holding them to maturity is one strategy. It is difficult however, to achieve broad enough diversification with just a few bonds. Bond funds such as low-cost, exchange-traded bond funds may, if carefully chosen, be the answer.

One strategy to consider: the purchase of a laddered bond ETF comprised of a collection of bonds with one- to five-year staggered maturities. Available in both the corporate and government bond sectors, such ETFs may hold 30 or more individual bonds. The 20 per cent of bond holdings within the ETF which expire each year are replaced by new five-year term bonds. The investor is therefore much less exposed to capital-value losses as rates increase – because he also gradually participates in the higher market rates.

The value of portfolios holding significant bond components was most evident when the equity markets tumbled dramatically in 2008-09. Such portfolios had a much softer decline than those more equity-based. This risk-mitigating characteristic will remain important in the future.

One more key consideration: The above strategy is sound as far as it applies to registered holdings, such as RRSPs, RRIFs, TFSAs, RESPs, or RDSPs – because taxes are a non-issue with respect to the interest earned. However, for non-registered portfolios, one should generally avoid investments which generate interest. This would include bonds or bond funds.

For non-registered portfolios, the investor can consider Canadian-preferred share holdings as a substitute for bonds in his fixed-income component. These pay a dividend, rather than interest. Dividend payments from Canadian corporations are eligible for a dividend tax credit, which dramatically lowers the tax impact. In B.C., an individual can earn up to $41,000 in a year before the dividend portion of such income attracts tax. Interest income on the other hand would be taxed in the same manner as employment income – at the investor’s tax rate.

Again as with bond-based investments, for maximum safety through diversification, consideration should be given to Canadian funds which often hold a large cross-section of corporate preferred shares. Even in today’s low-interest environment, a dividend yield approaching five per cent is possible with such products.

An appropriate proportion of fixed-income products should exist in every portfolio. However, as interest rates begin to increase, our choices of specific investment products must strive to carefully reduce the emerging risk to capital values.

A retired corporate executive, enjoying post-retirement as a financial consultant, Peter Dolezal is the author of three books. His most recent, the Smart Canadian Wealth-Builder, is now available at Tanner’s Books, and in other bookstores.