Rob Carrick's recent report on bond investing
This recent article by Rob Carrick's from globeandmail could be
a useful source of information to those interested in bonds.
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Do the right thing: Own bonds.
Even with interest rates expected to rise this year and next?
Of course. Sensible portfolio construction is based on your personal needs
and risk tolerance, not interest rate forecasts. You don't have to be a
passive victim of rising rates, though. There are several measures you
can take to help the bond side of your portfolio survive rising rates
with a minimum of damage.
First, a quick review of bond market basics. The price of bonds and
bond funds goes down when interest rates rise, and vice versa. If you
own individual bonds, you'll see some price decreases in your account
statements that will distract you from the fact that you'll still get
your money back when the bonds mature. If you own bond mutual funds or
exchange-traded funds, then price decreases can only be reversed when
interest rates fall again.
There are rate increase skeptics out there who think the economy won't
soon recover to a level where higher borrowing costs are needed to
stave off inflation. In that case, there's an argument for avoiding
bonds because the returns of the moment are so low. But either way -
rising rates or steady rates - you need bonds.
"We recommend having a portion of a portfolio in bonds, even if they're
not expected to do well," said Warren MacKenzie, president of the advisory
firm Weigh House Investor Services. "You have to protect your capital, and
bonds will do better than the stock market if we have another downturn."
There are questions about when interest rates will move higher, but it's
a done deal they will rise at some point from today's historically low
levels. Let's look at how to get your portfolio ready.
François Bourdon, manager of the Horizons AlphaPro Fiera Tactical Bond
Fund, has been preparing for higher rates by moving into shorter-term
bonds. A key rule for bonds in a rising rate world: Short term bonds
hold up better than long term bonds. Put a little more bluntly, they
will fall less in price.
Mr. Bourdon said the average duration of his portfolio - that's the
time required for the bonds to repay the cost of buying them - has been
shortened to four or 4.5 years over the past six months from six years.
"The idea is that as interest rates move up, we will not suffer as much,"
Mr. Bourdon said.
If you're investing in bond mutual funds, you can find the duration using
the Morningstar.ca website (see chart). For bond exchange-traded funds,
consult ETF company websites. Mr. Bourdon said a good rule of thumb
for duration in a time of rising rates is to keep it between three and
five years.
With an average weighted duration of three years, a one-percentage-point
increase in rates would cause a bond fund to fall three percentage
points in value. However, the interest payments from the fund would
likely offset that loss and leave you flat. "If this happens in a good
economic environment, your stocks will make up for it," Mr. Bourdon said.
Horizons AlphaPro Fiera Tactical Bond (HAF.UN-TSX) is a closed-end
fund with about 40 per cent of its assets invested in corporate
bonds through an ETF called the iShares CDN Corporate Bond Index Fund
(XCB-TSX). Closed-end funds and exchange-traded funds both trade like
stocks - they differ in that the former employs a manager to pick bonds
or stocks while the latter is primarily a tool for tracking stock and
bond indexes.
Government bonds are the most vulnerable to rising rates, but Mr. Bourdon
said corporate bonds will fall in price, too. That's why he'll be paring
down his exposure to them to something like 35 per cent of the portfolio
and putting the proceeds into a short-term bond ETF called the iShares
CDN Short Bond Index Fund (XSB-TSX).
Why keep such a big portion in the corporate bond ETF? Mr. Bourdon
explains that corporate bonds offer higher yields than government bonds
(with more risk), the duration of XCB is reasonable at 5.3 years and
the holdings are diversified across 348 different bond issues. Also,
the outlook for corporate bonds is tied in part to the health of the
economy, and rising rates suggest a robust level of health.
Mr. Bourdon also plans to reduce his holdings in an NYSE-listed ETF
that holds high-yield bonds - the iShares iBoxx $ High Yield Corporate
Bond Fund (HYG). The outlook for high-yield bonds is even more tied
to the economy than corporate bonds, so rising rates aren't the issue
here. Rather, it's that high-yield bonds have surged in price over the
past year and warrant some profit-taking.
Views on holding corporate bonds differ widely among advisers. Weigh
House's Mr. MacKenzie thinks high-quality corporate bonds should account
for about 25 per cent of an investor's overall bond holdings. He estimates
the benefit to be an extra 0.5 to one percentage point of yield.
Calgary-based investment adviser Kevin Cork avoids corporate bonds
and their riskier but higher-paying cousins, high-yield bonds. "The
returns on them can be tremendous," he said. "But for a lot of people,
they require an extra layer of understanding and risk tolerance."
For an investor with a 50-50 split between stocks and bonds, Mr. Cork
said he'd put 30 per cent of the bond holdings in a diversified bond
mutual fund, 10 per cent in a money market fund and the final 10 per
cent in a real-return bond fund.
The diversified bond fund is all about having an investing professional
navigate the rate landscape for you, the money market fund is about
keeping money safe (at the expense of returns) and the real return
bond fund is to provide portfolio protection if inflation jumps. For
"extra nervous" clients, Mr. Cork might use a short-term bond fund or
a mortgage fund instead of a regular bond fund.
An alternative to short-term bond funds is to build a ladder of bonds
or guaranteed investment certificates. That means equally dividing your
investments into GICs with maturities of one through five years. Last
week's Portfolio Strategy was all about using GICs as a replacement for
bond funds, and you can read it at
http://tgam.ca/GfP.
Warning: Rising rates will make it uncomfortable to own bonds and bond
funds. So prepare as best you can and remember that not having bonds
puts you first in line to get hit if the stock market blows up again.
****
Gauging the downside risk of bond funds
Look for the weighted average duration of your fund, which is the
time needed to recoup the cost of buying the bonds in the fund's
portfolio. Here's how to find out about duration:
Bond mutual funds:
Go to: morningstar.ca/globalhome/industry/FundCompare.asp
Bond exchange-traded funds:
Go to ishares.ca, claymoreinvestments.ca, bmoetfs.com or hapetfs.com
Look up bond ETF profiles to find duration information
****
Playing defence with bonds
With an eye toward rising interest rates, we asked a couple of investment
advisers how they would
structure the bond side of a client's portfolio. The target investor
here is someone who is reasonably conservative and has a portfolio evenly
split between stocks and bonds.
Using Mutual Funds The 30-10-10 Mix
Suggested by Calgary investment adviser Kevin Cork
30% of the portfolio: A diversified bond fund
Mr. Cork uses: TD Canadian Bond, Trimark Canadian Bond, PH&N Bond,
Fidelity Canadian Bond
10% A real-return bond fund
Mr. Cork uses: TD Real Return Bond, Mackenzie Sentinel Real
Return Bond
10% A money market fund
Mr. Cork uses a variety of funds in this category: low fees
are key.
Using Exchange-Traded Funds The 20-20-10 Mix
Suggested by Warren MacKenzie of Weigh House Investor Services
20% of the portfolio iShares CDN Bond Index Fund (XBB-TSX)
20% Claymore 1-5 Year Laddered Corporate Bond ETF (CBO-TSX)
10% iShares CDN Real Return Bond Index Fund (XRB-TSX)