Don’t Get Infected by Bond-itis

With inflation and rising rates worrying investors, dumping fixed-income securities is a temptation. But history shows that can do more harm than good, writes Rob Carrick, reporter and columnist for The Globe and Mail. [Note: Bond rates and bear markets mentioned are Canadian, and the numbers are usually comparable but not a match for the US equivalents—Editor.]

Stop worrying so much about bonds.

Yes, individual bonds and bond funds will fall in price when interest rates start to rise, as they eventually will. But some research by Ghattas Dallal, a senior analyst with CIBC World Markets, suggests bonds at their worst are much less risky than stocks.

"Bonds are low-volatility investments," Dallal said. "We stress-tested bonds over the past 61 years of market data, and we figured out that the downside risk for them is contained."

Dallal’s research shows the worst period for Canadian bonds ran from June 1980 to July 1981, a period of soaring interest rates and rampant inflation in which the prime rate at the big banks surpassed 20%.

The total return for the bond market then—price change plus interest paid—was a loss of 11.4%, according to Dallal’s research. That’s a sharp decline, no question. But it’s nothing compared to these stock-market declines in 2008 and 2009:

• The S&P/TSX composite total return index (including dividends) fell 48.5% from peak to trough.
• The S&P 500 index fell almost 41% in Canadian dollar terms, including dividends.
• The MSCI World Index fell 41.8% in Canadian dollars, including dividends.

Investors bonded with bonds as the stock market crashed because they fulfilled their mission of providing stability in dangerous times. Now, with interest rates expected to rise as economic growth firms, and inflation creeping into the economy from high oil and food prices, there’s growing concern that bonds are going to be a money-losing investment looking ahead.

Maybe so. But getting rid of your bonds or bond funds is the wrong approach. Re-jig your bond holdings, sure. But stick with bonds in general and don’t sweat the downside if you have a long-term perspective.

"Bonds are an essential element of a diversified portfolio," Dallal said. "You cannot live without bonds."

Investors have a clear tendency to jump in and out of bond funds. In June, a scary month for stocks, the mutual-fund companies that are members of the Investment Funds Institute of Canada reported net sales of $214 million in Canadian bond funds.

Over the first six months of the year, a period of optimism on the whole, bond fund redemptions exceeded purchases by $747.5 million.

The smart approach: Figure out a sensible mix of stocks and bonds for your portfolio based on your age, risk tolerance, and returns required to meet your goals. Then let it ride.

One reason why investors get overly torqued about bond risk is a tendency to focus too much on what the Bank of Canada is doing with rates.

Dallal said the typical investor’s bond holdings are influenced mainly by what’s happening with medium- and longer-term bonds. If a central bank pushes rates higher, these bonds won’t necessarily be affected.

In 2005, he points out, the US Federal Reserve raised its reference rate by a very sharp two percentage points in total, while the yield on the 30-year US Treasury bond actually fell 29 basis points.

Inflation is the big driver of prices for the kind of bond portfolios that individual investors have, Dallal says. And what happens when inflation builds?

For answers, he looked at bull and bear markets in Canadian bonds going back to January 1950. Bear markets were defined as a prolonged decline of 4% or more, while bull markets were defined as a broad upward move in bond prices.

The average bear market for bonds was a decline of 7.1% lasting eight months, Dallal found. Bull markets for bonds lasted 48 months on average, and produced gains of 60.4%.

We’ve been in a bull market for bonds since 1994, Dallal said. Today, the threat of rising rates and inflation is such that you’ll sometimes hear talk of a bond bubble.

That’s the kind of hyperbole we’ve had to put up with since the investment community was scared half to death by the financial crisis—if something rises a lot in price, slap a "bubble" label on it.

For a good argument why there’s no bubble in bonds, check out this video I did with Sheldon Dong, vice-president of fixed-income strategy at TD Waterhouse. Basically, he argues that bonds, with their characteristically modest returns, don’t fit the speculative profile of a bubble investment.

Financial bubbles also tend to pop in a very messy way. But, again, bonds don’t fit the profile.

Remember the 11.4% drop for the Canadian bond market back in 1980-81? Dallal found that it took only four months for the bond market to recover. The worst case in the period between 1950 and June 2011 was a slump in the mid-1990s that lasted 12 months.

Still jittery about bonds? Dallal looked at rolling three-year annualized returns dating back to January 1950, and the worst result for bonds was a decline of 2.3%. The comparable worst decline for Canadian stocks over a three-year period was 11.1%.

These rolling returns were calculated by taking 36-month slices of data, say January 1950 through December 1952, then bumping them ahead by a month to February 1950 through January 1953, and so on.).

Negative three-year returns for bonds occurred only in 0.4% of the periods examined by Dallal. When he narrowed his analysis to the period from January 1950 to December 1980, where interest rates were generally on the rise, he found negative three-year returns only 0.8% of the time.

Bonds never lost money in any five-year rolling period in Dallal’s analysis. Canadian stocks had five-year losses 1.3% of the time.

Mr. Dallal has two suggestions for investors who want their bond holdings to hold up as well as possible during a period of rising rates. One is to focus on short-term bonds, or those maturing in less than five years. Note that you’ll get a lower yield with short-term bonds than you would with those maturing over longer periods.

Another approach is to mix some corporate bond exposure into your portfolio. Dallal said that as short-term interest rates rise, corporate bonds tend to outperform government bonds.

Adjust your bond holdings to prepare for higher rates, but don’t sell them. History shows bonds are much less risky than stocks, and they’re quick to recover when they do lose value.