Time to get out of bonds?

The last few years have been very good for bond market returns in North America. Historically, bonds rarely outperform the stock market for long periods of time but the U.S. financial crisis of four years ago sparked a huge bond rally of epic proportions. No one ever anticipated that interest rates would plummet in a very short period of time but the U.S. financial crisis of 2008 did exactly that.

With interest rates plummeting to just about zero in 2008, the bond market by default, just won the Powerball of all lotteries. The perfect storm that decimated that U.S. real estate market in 2008 turned out to be fantastic news for the holder of just about any type of bond - government bonds, corporate bonds, junk bonds. Everything that is - except for mortgage backed bonds.

In previous articles, I explained the "teeter-totter" principle of bond valuation: "Interest rates go up - bonds go down" and vice versa. On one end of the teeter-totter is the price of the bond, the other end is the current level of interest rates or the yield of the bond. If interest rates plummet, this is absolutely fantastic news[for bonds] because the value of your bond has just skyrocketed. Remember the teeter-totter? If one end of the teeter-totter goes down, the other end goes up.

The bond party is still in full swing and everyone is having a jolly good time collecting all those capital gains. I hate to take away the punch bowl at the height of the bond party, but I am obliged to tell you that bonds can be as risky or in some cases, riskier than stocks! A 10 year U.S. government bond yields about 1.60%.[1] A Canadian 10 year government bond yields not much more at 1.7%. Considering that a much shorter term 5 year term Canadian GIC (Guaranteed Investment Certificate) yields 2.5% what does this tells us about these bonds? What it tells us is that bonds have become expensive.

Because the price [of the bond] is high, the interest rate on the bond is low. When interest rates plummeted (think a stone tied to the end of a rope), the price of the bond soared in many cases, to prices over their maturity values. There's that teeter-totter effect once again; interest rates go down, bond prices go up. In this case, way up!

So, what has been keeping the bond party going? Interest rates drifted lower in 2012 which was good for bonds and continued to fuel their returns. If interest rates continue to fall even further, bonds could possibly, squeeze out a bit more in gains but how much lower can we go? Occasionally, I receive queries from clients seeing advertisements about very high returns on bonds. These are likely to be high yield aka "junk bonds". These issuers of junk bonds are not investment grade and they can be risky investments. If the corporation goes bankrupt or can't pay its debts, you could lose most if not all of your bond.

The promise of higher yield is commensurate with increased risk. Buying bonds on your own could be a risky business. For accounts with relatively few holdings, one default caused by the bankruptcy of the issuer of the bond, could wipe out a decade's worth of gains. As world economies recover, it will be even harder for central bankers to keep interest rates artificially low.

[1] approx. yield mid-December 2012

The convoluted world of bond pricing

A very small bond trade of say, $10,000 may be expensive to buy as most brokers would be obliged to charge at least a minimum commission per trade. When you add the price of the bond plus a commission, your actual yield could be substantially less. The commission for the purchase of the bond is embedded in the price of the bond and unlike a transparent bond mutual fund purchase, may not be disclosed as a separate cost.

You should always ask your broker what the commission is and what the calculated yield to maturity is with the commission included. Since there is no true public market in Canada for bonds (unlike the stock market) it is very difficult to confirm prices on thinly traded securities. The price of the same bond can vary from firm to firm.

It is extremely important to always have a sufficiently diversified portfolio of securities. In order to spread out the risk among dozens of different bonds, I would generally recommend buying a mutual fund specializing in the bond sector rather than buying the individual bonds themselves.

What are the bond gurus saying right now?

There is no consensus on what the bond market is going to do in the short term but some high power talent seems to be raising some red flags. According to the Canadian Investment Guide 2013 [2] here are some notable quotes:

"The tables have turned. Whereas fixed-income[bonds] have been a great place for a 30 year period, those yields are going to be quite low." - Bob Gorman, VP and Chief Strategist, TD Waterhouse Canada Inc.

"I definitely would be underweight bonds in the current environment." "The potential for some sort of rate increase down the road could leave bonds in a loss position" - Paul Taylor, Chief Investment Officer, BMO Asset Management

Perhaps the person with the greatest loathing of bonds has to be Warren Buffett - arguably the world's greatest and most successful investor who refers to bonds:

"Most of these currency-based investments are thought of as "safe." In truth they are among the most dangerous of assets. Their beta [volatility] may be zero, but their risk is huge. "Current [interest] rates however, do not come close to offsetting the purchasing-power risk that investors assume. Right now bonds should come with a warning label."

-Warren Buffett is the primary shareholder, chairman and CEO of Berkshire Hathaway and consistently ranked among the world's wealthiest people. He is widely considered the most successful investor of the 20th century.  http://finance.fortune.cnn.com/2012/02/09/warren-buffett-berkshire-shareholder-letter/

[2] The CIG 2013 magazine is an annual publication co-authored by the Investment Executive and the Morningstar Canadian Investment Awards.

Summary of bond pricing & risk factors

Remember the teeter-totter bond rule:

"Bond prices go up - the yield goes down. Bond prices go down -yields go up."

 or

"Interest rates fall -bonds go up in price. Interest rates go up - bonds go down in price."

Bonds can and should be used to build suitable and appropriate investment portfolios for many investors.  However, as Mr. Buffett says, bonds should not be referred to as "safe" investments. Bonds do have their own sets of risks and you can undoubtedly lose money with this asset class under certain market conditions. It would be very difficult and expensive to build a sufficiently diversified bond portfolio on your own with limited funds.

Beware of rapidly rising interest rates if you are a bond holder. It is best to hire a professional money manager to invest in the bond market for you. Please ask me about the choices available for professional managed bond mutual funds.  Give me a call or drop me a line at gszlagowski@assante.com.

[Editor's note: the word "teeter-totter" might elicit a blank look from many parts of the U.S. where it is better known as a "see-saw". The use of the term 'see-saw" would likely elicit the same blank look in Canada. Origins of the word "teeter-totter" are somewhat difficult to find - perhaps Middle English or Norse origin.

Bond gotcha

The price of a bond can change every day due to supply/demand, changes in current interest rate levels, changes in credit quality, etc. The price of a GIC does not change. Once a GIC is purchased, it does not vary in price and because it does not change in price there are no capital gains or losses to worry about.  It is unaffected by interest rates, so if rates suddenly skyrocket you are not faced with the possibility of significant losses. If you meet an untimely end, your GIC's value is worth exactly what you paid for it plus you will have accumulated full interest until the day you die.

You never want to die if you own a bond and interest rates have jumped after you bought it. Although your intention was to hold your bond to maturity and not bother with the ups and downs in the interest rates, the grim reaper may not wait until each of your bonds mature. Although you may have wanted to hold your bond to maturity, it is very likely that your estate will not.  In my experience, most estates sell or cash out all of the investments of the deceased and distribute the cash to the beneficiaries as per the Will. If you have to sell a bond in a rapidly rising rate environment, the estate could be hit by significant capital losses - certainly not the intent of the bond holder's wish to preserve and pass down an inheritance to the kids. Lesson learned: Bonds are not necessarily safe investments in all market environments.