Bonds: A predictable future income

The standard method for protecting assets is diversification, both among and within asset classes. Yet, diversification alone is not the answer. After all, by early March 2008, major stock market indices in the U.S. and Canada were down by one-third to one-half compared with their values the previous year. While the equities markets have recovered, there have been other times — notably, the 1930s — when sagging markets and rampant bankruptcies devastated personal fortunes for a decade. Clients who could not wait for the markets to recover or who just needed cash had to sell at bargain-basement prices. Diversification into more than one asset class, including bonds, is vital to putting a floor on the portfolio’s value. And, for a retirement portfolio with a long time horizon, it is essential.

Stocks inevitably beat bonds over the long run. However, stock cycles, which average 38 to 44 months, are shorter than bond cycles, which run over decades. In the 30 years ended June 30, 2013, stocks had major price declines in 1987, 1991, 2001 and 2008. Bonds rose in price rather steadily in those 30 years. It is safer to bet that a long-term bond-price cycle will persist than that stocks won’t be falling at some point.

For now, with bonds in a “down” price cycle, stocks may seem the better bet. But investment-grade corporate bonds with terms of five or 10 years will revert to cash at maturity, enabling your clients to have several entry points into equities markets if they wish and, of course, give them known amounts of money at any date before or during retirement.

“Using bonds to cover expenses that you can predict in retirement is exactly what insurance companies and pension funds do to match their future liabilities,” says Benoît Poliquin, chartered financial analyst and lead portfolio manager with Exponent Investment Management Inc. in Ottawa. “If you recognize future large-ticket expenses that might include buying a retirement home, then you can buy the future value today, at a discount, with bonds.”

Buying bonds now for known future expenses works only with actual bonds. It does not work with bond funds, whether mutual funds or exchange-traded funds (ETFs). Investment funds can generate gains or losses and carry them forever. If your client needs money from a bond fund, he or she has to take the market price. And, without a binding maturity date, it is impossible to predict years in advance what the fund units will be worth. (Of course, target-date funds do this, but with embedded costs.)

The question is: buy the bond, or buy the bond fund or bond-based ETF?

The answer is structural. If your client can hold to maturity, the actual bond will have entirely predictable value at any time prior to term and at term. If the client wants to trade bonds or is prepared to accept the ability of investment funds to carry capital gains and losses indefinitely, then a fund may be the better deal. You have to compare the certainty of the bond’s payoff with the fact that a fund can trade bonds at low cost and may have wise management. Include in your calculations the fees that bond funds charge.

Bond ETFs may add “defined maturity” strategies. ETFs holding long bonds or shorts, or one- to 10-year ladders, for example, are a compromise. Like mutual funds, these ETFs’ fees reduce clients’ returns and thus increase risk.

Investment-grade bonds won’t appreciate in an economic climate in which interest rates are expected to rise. But bonds can preserve capital, especially for clients headed into retirement who do not want or need equities risk. Bonds are no way to get rich, but they remain a very good way for your clients to avoid getting poor. IE