Kiplinger

Recent repeated hikes in Canadian mortgage rates seemingly are telegraphing a rise in interest rates some time this summer. In a piece flagged by AdvisorAnalyst.com — The Bond Roller Coaster –  Tacita Capital’s Michael Nairne warns “the good times for bonds couldn’t last forever” and suggests investors recognize that “in the next year or so the bond roller coaster is about to get underway.”

Nairne [pictured left from a Wealthy Boomer video with me] says investors have enjoyed an unprecedented three-decade bull market in bonds  since long-term government bonds peaked at 14.8% in September 1981. If you’re a baby boomer, that 30-year stretch probably constitutes most of your awareness of financial markets and investing. Click on Nairne’s article and you’ll see some interesting charts on long-term government yields versus inflation.

Unfortunately, a roller coaster implies you don’t know when the rises and falls will occur. Many advisors I’ve talked to — notably ValueTrend Wealth Management’s Keith Richards, who I quoted in this piece in March — have been counselling clients to reduce exposure to long bonds since they are most likely to fall in price as interest rates rise. However, Nairne cautions that “some longer-term bond exposure is needed today as a hedge against a deflationary scenario.”

Even if you dump long-term bonds, the problem arises of what to do with the proceeds. You can sit in cash and money market funds and earn virtually nothing while waiting for a rate rise that may or may not come. Or you can take more risk and stretch for yield in dividend-paying stocks, income trusts, preferred shares, REITs and alternative investments. 

Rate hike could also derail stocks in next year or so

The problem is, as Kiplinger Personal Finance notes in this piece Friday — What a rate hike means for investors — an interest rate rise will eventually also derail the bull market in stocks. The writer, senior associate editor Andrew Tanzer [pictured, right], predicts this may not happen until early 2011:

 “There’s little doubt that rates are heading higher. After a three-decade decline, they have nowhere to go but up. For stock investors, what matters is how high and how fast.”  One of his sources thinks the trigger for a stock slump would be a 5% yield for 10-year treasury bonds.

But how likely are 5% yields given a fragile housing market, stubborn unemployment and limited bank lending? The Federal Reserve Board still insists that very low interest rates are justified “for an extended period,” given the shaky economy and expectations that inflation will remain benign. 

Why a laddered approach to bonds still makes sense

I’ll point readers to one more web link: the presentation from Odlum Brown Ltd.’s fixed income strategist, Hank Cunningham: Risks to Fixed Income Portfolios.  I mentioned this in last week’s blog about the firm’s equity ace, Murray Leith, but Cunningham — author of In Your Best Interest — is certainly worth listening to as well, especially if you’re an older investor heavily invested in bonds.  In the column in the paper cited above, Cunningham cautioned against Richards’ “sell long bonds” stance by advocating fixed income portfolios balanced by diversifying credit risk and investing in a “laddered” broad spectrum of maturities.

Cunningham — pictured left — notes that as the economy started to grow, the spread between 10-year Government of Canada bonds and two-year bonds peaked in January at 231 basis points and has since narrowed to 180 basis points. The yield curve flattened because the two-year yield rose: “Simply put, the market is not waiting for the Bank of Canada to raise rates.”

But he adds that the U.S. yield curve remains mired at its all-time high, “indicating that their recovery is not getting underway.”

Little evidence inflation pressure merits overexposure to Real Return Bonds

Despite “media hysteria” over inflation, Cunningham sees little evidence a sharp rise is imminent. In fact, there are pockets of deflation, notably in Japan and some of the PIG economies of Europe (Portugal, Ireland and Spain). Cunningham therefore expects positive returns from a “laddered portfolio of conventional, investment grade, corporate bonds.”

If inflation did start to heat up, bond investors would get some protection from Real Return Bonds (or in the U.S., TIPS or Treasury Inflation Protected Securities). But Cunningham would not put 100% of a bond portfolio in RRBs or TIPS because there is still the risk of deflation and real yields could rise, producing negative performance. “Our view is that conventional bonds will outperform RRBs for the foreseeable future.”  Also, because of their long durations, RRBs can be volatile.

On the currency side, Cunningham says Canadian investors should brace for “sizable swings” in the loonie. He recommends that fixed income investors remain in C$-denominated bonds if they plan to retire in this country.  In his presentation, Cunnigham shows a portfolio of domestic corporate bonds laddered from January 2011 to as late as February 2017. Even if interest rates rise 1% such a portfolio would produce a positive 3.3% return. Odlum Brown also offers an all-government ladder, a Zero Coupon Ladder and an all-corporate one-to-ten year ladder.

In short, Cunningham’s solution to the bond roller coaster ride is to maintain a laddered approach that “minimizes downside risk while producing positive returns.”

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