Myth Busting Of The Bonds In Your Portfolio

We preach balance in your portfolio. Balance between stocks and bonds (fixed income). Most of us know how stocks work (more or less) and that they are considered to be somewhat more risky than bonds (which will ultimately depend on the issuer of the bond).

For the moment let's focus on government bonds because they are the safest: Moody's Investor Service grades Canadian Government Bonds as Aaa (which is the highest level offered).

Generally, the safer the bond, the lower the interest income that the bond issuer will have to pay. Interest is usually paid semi-annually.

The math for bonds can be complex and confusing, but basically, because the interest income is fixed (i.e. fixed income) at the interest rate attached to the bond when it is issued for a set maturity date: when interest rates rise, the bond gets discounted in price as new bonds are issued at the higher interest rates and the bond becomes less valuable (bond price falls) at that moment. The opposite occurs when interest rates fall: the price for the bond will rise.

If you bought the bond when it was issued and hold it until its maturity, you will receive your initial investment at the original purchase price (we call that par value) and for the number of years that the bond has existed you have received the semi-annual interest payments.

However, bonds trade daily in a secondary market and the prices for those bonds adjust relative to the state of the economy and most importantly inflation and future interest rate expectations.

So bond prices move, up and down (which adds another dimension of risk).

The questions that we seem to get asked rather often are related to:

1) The coupon or interest rate: why own a bond that is only paying 1.5%? 

2) What maturity is best to own when interest rates are going up (or when they are going down)?

1) is relatively easy: in 2008 when all financial assets with any risk attached to them fell in unison, only cash and high quality government bonds were desired and prices rose (interest rates fell). It is wise to have the safety of those two asset classes when risk is high (as we believe it to be today).

2) is more difficult to understand, so lets use this chart:

The gold line is the yield (relative to the price and coupon) for Canadian government bonds for each of the maturity dates from 3 months to 30 years on January 1 2016 (we call this the yield curve).

The green line is the yield curve (same maturities) at the close of business yesterday. 

Between then and now, the Bank of Canada has raised rates 2x by 1/4% each time.

The myth that confuses most advisors and investors is that if interest rates are going up, then prices of shorter term bonds will go down less than longer term bonds and as a result you should own shorter (duration) bonds in your portfolio.

That has certainly not been the case this year: with inflation remaining low, longer term bond investors have not been demanding a premium (higher yielding bonds) for inflation protection and as the Bank of Canada tries to preempt future inflation (by raising short-term rates), longer term bonds (15 year maturities and beyond) have actually gone down in yield (up in price).

In essence, then, one should have had a longer term duration in their bond portfolio.

A client who recently joined us transferred in a portfolio full of short-term bond ETF's. Clearly, his advisor had mis-positioned him / her.  No wonder their portfolio was under-performing the benchmark.

If inflation jumps higher, then we need to be concerned about longer term bonds. However, at the moment, that does not appear to be the bond markets concern. In fact, as I mentioned in yesterday's blog, the flattening of the yield curve has potentially greater significance.