Do bonds still make sense?

The Fed’s move adds duration risk and signals capital markets to buy stocks rather than bonds by pushing down the long end of the yield curve, says Marc Stern, vice president, portfolio manager and head of discretionary wealth management with Industrial Alliance Securities Inc. in Montreal.

Investors duly took that cue and, in the days following the Fed’s Sept. 13 announcement, stocks in the U. S. and Canada rose while U. S. and Canadian bond prices fell, pushing up yields in the biggest surge in three years, according to Bloomberg LP. You could almost feel the ground shaking as the herd of investors stampeded out of fixed-income.

The Fed has said that its highly accommodative stance would remain in effect even after the recovery strengthens. The market has interpreted his statement, says Chris Kresic, partner and co-lead for fixed-income with Jarislowsky Fraser Ltd. in Toronto, as meaning that interest rates will remain suppressed to mid-2015.

Moreover, the Bank of Canada cannot stray far from the Fed’s policies, Kresic adds: “Any time the Fed initiates QE actions, it puts off the eventual start date for Bank of Canada tightening. Historically, there is 90% correlation between U. S. and Canadian interest rates.”

Clearly, the central banks are risking stoking inflation as they prod their economies.

In this climate of relentlessly low rates on government bonds, bond portfolios have to be adjusted for term exposure, inflation risk, credit risk, currency exposure and, in balanced portfolios, overall bond allocation.

TERM ADJUSTMENTS. The Fed’s position, which influences the tone of Canadian and other credit markets around the world, is that government bondholders will not be rewarded for several years. The long end of the yield curve has become a lot less attractive.

In Canada, bond portfolio managers have reacted to QE3 by shortening average duration, thus reducing their overall portfolio risk, says Rémi Roger, vice president and head of fixed-income with Seamark Asset Management Ltd. in Halifax.

INflATION RISK. Inflation fears heightened by QE3 have boosted U. S. Treasury inflation-protected securities (TIPS), whose yields have climbed swiftly to 2.6% over yields on 30-year conventional U. S. treasuries from 2.38% the previous week. In the week after Sept. 13, real-return bond (RRB) prices also rose slightly. Further gains in TIPS and RRBs are likely.

CREDIT RISK. With government bonds paying pittances, the obvious move is into corporINV ate bonds. For instance, a 2.75% Government of Canada issue due June 1, 2022, has recently been priced at $107.49 to yield 1.9% to maturity, slightly more than the predicted 1.7% inflation rate for 2012 and slightly below the 2. 2% an t ic i p a t ed next year by Bank of Nova Scotia’s economics department. In contrast, a Telus Corp. 9.65% issue due April 8, 2022, has recently been priced at $148.90 to yield 3.56% to maturity.

Furt hermore, a smattering of junk bonds doesn’t hurt. An exchange-traded fund (ETF) such as iShares Advantaged U. S. High Yield Bond Index Fund (hedged in Canadian dollars) has a 50-basis-point management expense ratio and a 7.2% yield. The risk is moderate if the portfolio’s allocation to junk is modest.

CURRENCY RISK. Inflation fears have caused the U. S. dollar (US$) to drop against the loonie and other major currencies. Following the Fed’s Sept. 13 move, the loonie gained 1.5¢ vs the greenback; pundits claim the loonie could hit US$1.05.

“If the Fed continues to talk interest rates down,” says Jack Ablin, executive vice president and chief investment officer with BMO Harris Private Bank in Chicago, “and to expand the currency base by quantitative easing moves such as those in QE2, which ended in June 2011, and QE3, then the US$ is vulnerable relative to the currencies of our more prudent trading partners.”

Adds Kresic: “The US$ is not where we want to take our chances for our bond portfolios.”

BOND ALLOCATION. In the face of declining returns, portfolio managers have reduced bond allocations. So, what is the right allocation to bonds? It’s a moving target. If the stock market thrives, there will be profit-taking, Kresic notes. For now, he adds, bonds are more overvalued than stocks, and US$denominated bonds have unacceptable currency risk.

Given this full house of risks, Roger recommends that you: shift your clients’ money into corporate bonds that pay far more than government issues; shorten term and duration to reduce risk further; stick with big, investmentgrade corporate names; avoid U. S. exposure; and add RRBs to cover inflation risk.

In spite of the low yields on bonds, there remains a rationale for holding them, says Graeme Egan, a financial advisor and portfolio manager with KCM Wealth Management Inc. in Vancouver: “Bonds continue to stabilize portfolios and, although they may lose value in trading portfolios if held to term, they pay back their face value. Reinvest interest payments and you can ride rising interest rates when they happen. Finally, while stocks never mature, bonds eventually revert to cash. They are lifesavers for hard times.”

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