Don't let a fear of bonds infect your healthy portfolio

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," Mr. 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."

Mr. 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 per cent.

The total return for the bond market then - price change plus interest paid - was a loss of 11.4 per cent, according to Mr. Dallal's research. That's a sharp decline, no question. But it's nothing compared to these stock market declines in 2008-09:

- The S&P/TSX composite total return index (including dividends) fell 48.5 per cent from peak to trough.

- The S&P 500 index fell almost 41 per cent in Canadian dollar terms, including dividends.

- The MSCI World Index fell 41.8 per cent 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 when 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," Mr. 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. Mr. 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 U.S. Federal Reserve raised its reference rate by a very sharp two percentage points in total, while the yield on the 30-year U.S. Treasury bond actually fell 0.29 of a point.

Inflation is the big driver of prices for the kind of bond portfolios that individual investors have, Mr. Dallal says. And what happens when inflation builds? For answers, he looked at bull and bear markets in the Canadian bond market going back to January, 1950. Bear markets were defined as a prolonged decline of 4 per cent 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 per cent lasting eight months, Mr. Dallal found. Bull markets for bonds lasted 48 months on average and produced gains of 60.4 per cent.

We've been in a bull market for bonds since 1994, Mr. 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 Let's Talk Investing online 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-per-cent drop for the Canadian bond market back in 1980-81? Mr. 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? Mr. 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 per cent. The comparable worst decline for Canadian stocks over a three-year period was 11.1 per cent.

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 per cent of the periods examined by Mr. 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 per cent of the time.

Bonds never lost money in any five-year rolling period in Mr. Dallal's analysis. Canadian stocks had five-year losses 1.3 per cent 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. Mr. 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.

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A look back at the severity of bear markets for bonds going back to 1950. Note that rising bond yields mean falling bond prices.

Notes

-Trough date means the date on which the bond market bottomed out in a particular bear market period.

-The DEX Universe Bond Index was used here going back to its origin in 1980; prior to that, longer-term government bonds were used.

Source: CIBC World Markets