Bond investing, considered by many people to be dull, can be attractive for clients in or heading into retirement. Direct ownership of bonds offers a return of face value if the bonds are held to maturity, although lower-rated bonds are not without default risk.

Often, bond returns are low. The average yield on Government of Canada bellwether 10-year bonds hovers around 2.5% before taxes and any inflation adjustments. Provincial bonds offer an average of a 30-basis-point (bps) to 50-bps pickup on yields. Corporate bonds, depending upon their credit rating, can add 100 bps to 300 bps to 10-year government-bond yields before moving into the high-yield (HY) space.

For example, a Government of Canada 2.5% bond due June 1, 2024, recently was priced at $104.78 to yield 1.95% to maturity. By comparison, a Chartwell Real Estate Investment Trust 4.9% bond with a similar maturity recently was priced at $108.26 to yield 3.78% to maturity.

Holding bonds inside a tax-free savings account helps with the disadvantage of low returns, says Benoît Poliquin, chief investment officer with Exponent Investment Management Inc. in Ottawa.

The range of choices for fixed-income portions of clients’ portfolios is vast, from actual bonds to bond packages in actively managed mutual funds and exchange-traded funds (ETFs), as well as passively managed, index-based ETFs. There also are inflation-linked bonds or packages of laddered government and corporate bonds that can take advantage of rising yields. As well, humble guaranteed investment certificates provide a fixed income, guaranteed return of principal and a known value at redemption.

Bond type is important to goals

The choice of bond-based investment vehicle is crucial. As Caroline Nalbantoglu, head of CNAL Financial Planning Inc. in Montreal, notes: “Bond funds – managed or passive – that live forever are not as ‘fixed’ as an actual bond.”

Clients in or near retirement are concerned with cash flow and preserving capital. That means these clients’ portfolios should hold shorter-term bonds that don’t exceed the clients’ lifespan, says Chris Kresic, head of fixed-income and senior partner with Jarislowsky Fraser Ltd. in Toronto: “If [clients] stick to the investment-grade FTSE/TMX corporate bond universe, formerly the DEX universe, they should have reasonable protection from default.”

Still, care should be taken not to err too far on the side of safety. “When you compare a 10-year – and longer – Government of Canada bond with a high, investment-grade corporate bond of similar term, you can see a spread of 150 bps,” says James Hymas, president of Hymas Investment Management Inc. in Toronto. “The spread on yield is not all compensation for risk. Only 20 bps to 30 bps covers the credit risk. The rest is liquidity, and most retail investors give up too much yield to get the liquidity.”

Interest rate risk is key. “There is risk that interest rates may rise or fall and, if deflation breaks out, then equities would be at serious risk of major decline,” Kresic says. “Year to date [as of late October], interest rates have confounded many market strategists. Almost everybody expected rates to rise in 2014, but they did not. As a result, bonds put in a remarkable performance, the fifth-best bond rally in the past 40 years.”

HY bonds have suffered in 2014

HY bonds often are seen as lying on the uncertain ground between equities and debt: HY bonds are volatile, hard to trade as individual securities and sensitive to economic cycles.

And HY bonds have suffered in 2014. As Paul Sandhu, HY bond specialist with Marret Asset Management Inc. in Toronto, notes, HY returns for the year to date as of Oct. 21 are 4.5%, which trails the FTSE/TMX universe bond index by about 2%. Says Sandhu: “We’re neutral on whether you should buy in or not. For those with [HY] exposure, we’d suggest holding.”

Investment-grade beats HY for security, and diversified packages of bonds spread risk at low cost. Any ETF that mimics the broad index holds a lot of government bonds, Kresic says. But in corporate bond ETFs, it is essential to examine the portfolios and credit ratings to ensure the holdings are not concentrated in relatively risky sectors, such as mining or energy. In the HY sector of the bond market, 11% of the holdings are minerals and oil and gas, both of which are vulnerable to downturns.

Inflation is a major risk for bonds. If inflation rises, interest rates are likely to follow. Real-return bonds (RRBs) in Canada and U.S. Treasury inflation-protected bonds offer inflation protection. Compared with conventional bonds, RRBs are priced to assume an inflation rate of 1.9%. So, if inflation is higher, then RRBs’ returns will beat conventional bonds; if lower, or if deflation breaks out, the RRBs will underperform.

Over time, stocks do beat bonds – but with more volatility. Bonds make cash flow in retirement predictable and may, if deflation occurs, do a lot better than stocks.

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