The Baffling World of Bonds Explained

01/30/2012 10:30 am EST

Focus: BONDS

Rob Carrick

Columnist, The Globe and Mail

The small returns may be irritating.but when markets plunge, bonds keep disaster at bay, writes Rob Carrick, reporter and columnist for The Globe and Mail.

Bonds have to be the most maddening investment category right now.

Returns are so puny that they're a provocation to anyone living on investment income. Yet every time the stock markets plunge, it's bonds that keep disaster at bay in a portfolio. This is the background for a recent bond-fund buying surge.

To help investors better manage the bond part of their portfolios, let's check in with Hank Cunningham, a veteran of more than 40 years in the bond market and author of In Your Best Interest: The Ultimate Guide To The Canadian Bond Market, which was recently reissued in a third edition.

Cunningham is also fixed-income strategist at investment dealer Odlum Brown. What follows is an edited transcript of our conversation:

Rob Carrick: Hank, investors were big buyers of bond mutual funds and bond exchange traded funds in the latter part of last year. How much sense does that make after a year in which bond funds averaged 6.8% gains and the S&P/TSX composite fell 11%?

Hank Cunningham: None. It's too late. The performance of bonds in the past two years has been just off the charts, and I think the horse has left the barn this year.

Rob Carrick: What's your outlook for the bond market over the next year or so?

Hank Cunningham: I think yields will rise in the next 12 months by as much as 1% at the long end of the market. We're going to see a natural rise in yields, with Europe being the big "if."

Rob Carrick: Could investors lose money in bonds? Since 1985, bond funds have on average lost money only twice (a 2.6% decline in 1999 and a 5.4% drop in 1994).

Hank Cunningham: What you find is that it's difficult to lose money in bonds because of total returns. You get a price decline in bonds, but you get the income coming back.

Rob Carrick: What's the best way for an individual investor to own bonds-bond mutual funds, bond exchange traded funds, or individual bonds?

Hank Cunningham: I'm a very strong proponent of individual bonds in almost all cases, for the very simple reason that you know exactly what you're going to get. Bond funds never mature, and neither do bond ETFs.

Probably the minimum for investing in individual bonds is $50,000. For less than that, I'd go for ETFs and never mutual funds.

There's no reason to ever buy a mutual fund holding bonds. High fees in a low interest-rate environment mean you're going to be behind the starting line almost all the time.

Rob Carrick: What about GICs as a bond substitute?

Hank Cunningham: GICs can be used in bond ladders very easily for one- to five-year investments. They'll yield more than anything in the bond market.

Rob Carrick: How juicy are the commissions that full-service brokers work into the price that clients pay for bonds?

Hank Cunningham: I find the commissions are very fair. In my experience, they are very close to what you'd pay for an equity trade, between 0.5% and 1% (of the value of the trade).

Continued.

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Rob Carrick: Have you noticed that bond pricing in the discount brokerage world isn't as sharp as it is for stock trades?

Hank Cunningham: Yes, very much so. Every discount dealer has a different set-up for bonds. In my experience, TD Waterhouse discount brokerage is the best in terms of pricing, availability, and the tools they give you to work with.

Rob Carrick: What's your view on the traditional bond ladder approach, where you divide your bond holdings evenly into segments maturing every year for five or more years?

Hank Cunningham: It takes away guesswork.

A year ago, if you thought bond yields were going to rise, you would have kept all your money short term. Well, guess what. You would have missed a big rally in long bonds. At the same time, if you bought long bonds right now and yields go up, you just lost a lot of money.

What a laddered portfolio does is spread out your maturities so you never have your eggs in one basket. You always have something coming due to reinvest.

Rob Carrick: Should investors use a five-year ladder, or spread their bonds out over ten years?

Hank Cunningham: The yield spread between five-year GICs and ten-year Government of Canada bonds has averaged over 1.15% in the past 20 years. So if you stopped at five years, you've left a lot of money on the table.

Also, you can diversify more. I don't like having more than 10% in any one bond in my portfolio.

Rob Carrick: If you want protection against stock market plunges and a financial crisis, do you need government bonds as opposed to corporate bonds?

Hank Cunningham: If the world hits a credit crunch again, government bonds will outperform corporate bonds. We've seen that happen.

Rob Carrick: Some investors have been diversifying their fixed-income holdings with high-yield and emerging-market bonds. What's the best way to get exposure to these sectors?

Hank Cunningham: There are a couple of cases where I favor ETFs (as opposed to owning individual bonds), and emerging markets is one of them.

I think BMO has a good one [ticker symbol ZEF]. Your risk is spread out, and your money is hedged back to Canadian dollars.

I also like high-yield bond ETFs. I can't pick individual high-yield bonds-it's too risky.

Rob Carrick: How much should investors rely on high-yield and emerging-market bonds?

Hank Cunningham: I would say 5% to 10% of a fixed-income portfolio in each of high-yield and emerging-market bonds.

Rob Carrick: Do you consider preferred shares to be fixed income?

Hank Cunningham: Yes, I guess I do. I keep getting asked about them. They're a little safer and less volatile than the equivalent common shares.

Rob Carrick: What about real-return bonds?

Hank Cunningham: I view them with great skepticism right now. Real-return bonds yield-wait for this-0.3%, approximately, which is up from 0.15% a week ago.

These are very long duration, low-coupon bonds with tremendous price risk in them. I do not recommend them at this point.

Rob Carrick: When is the time to start looking at real-return bonds?

Hank Cunningham: You need some indication that inflation expectations are rising. It could take another year, and you could lose a lot of money in the interim.

Rob Carrick: We keep hearing about how investors frustrated by low bond yields should look at dividend-paying common shares-what about it?

Hank Cunningham: If an investor can handle the price volatility of common shares, then sure. Ten-year Canada bonds yield 2%, and Bank of Montreal yields 4.5%. Why wouldn't you do that?

But you have to do it very cautiously, and make sure it fits your risk profile.

Rob Carrick: Investors sometimes ask why they should hold bonds when the yields are so low they're below the inflation rate. What's your response?

Hank Cunningham: The return you get on your principal is not acceptable right now, but your money is safe. What room in your portfolio do you have for making sure you can sleep at night?

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