I receive many warnings of the pending bond bear market and how rising interest rates will crush bonds. Such messages usually are followed by pitches of solutions to this problem. Bonds are expensive, even after the recent yield spike; and it seems likely that yields will rise at some point. But all of this talk seems a little overdone.
– bonds’ role in portfolios. Bonds continue to play a vital role in clients’ overall portfolios. Bonds remain generators of stable – albeit low – income. Investment-grade bonds still offer protection against bear markets in stocks. Bonds can limit losses caused by stock market crashes and be a source of rebalancing cash – thereby accelerating recovery time.
– bond risks. Every one of the terrifying articles I’ve read on bonds focuses on long bonds – i.e., those maturing 20 to 30 years from now. Although many bond portfolios include some long bonds, the vast majority of retail investors hold mostly short- to mid-term bonds. So, the scary scenarios apply to institutional investors that go long to match long-term liabilities to immunize duration risk.
For retail investors, the biggest risk is hyperinflation, which is having the consumer price index rise in a single month by an amount equal to the cumulative total inflation in Canada over the past decade. If you think that we will inflate our way out of debt, then getting out of bonds is smart. Otherwise, there are higher probability risks.
Low interest rates have encouraged governments and corporations to extend their average debt maturities, which has pushed up our bond market’s duration. This has pulled up the durations of all benchmark-sensitive bond funds. Also, the lure to reach further along the risk spectrum to capture more yield is most tempting when rates are low – and when it’s most dangerous. And the securities sector is serving up higher-yielding alternatives at a rapid pace.
– alternatives. I can’t turn around without bumping into yet another new floating-rate note (FRN) fund, touted as a great performer during periods of rising rates. No argument there. But I have two concerns: first is that FRN funds generally invest in corporate debt – often with a big slice being below investment-grade.
So, this interest rate risk protection may come with a lot of credit risk, which ties into the second issue: regulatory documents generally show FRN funds as “low/medium” risk. You could have a very unhappy client – and maybe a lawsuit – during the next credit crisis. FRN funds protect against rising rates but are vulnerable to fattening credit spreads. The most recent time that happened – 2008 – FRN indices posted equities-like losses. One Canadian FRN fund lost half its value and has yet to recover.
Cash or high- interest savings accounts are the simplest and safest ways to protect against rising rates. But tread carefully before tossing bonds aside for more stocks or buying into the growing pool of new but risky portfolio “cures.”IE
Dan Hallett, CFA, CFP, is vice president and principal with Oakville, Ont.-based HighView Financial Group, which designs portfolio solutions for affluent families and institutions.
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