Inflation seems to be yesterday’s problem because it now seems to be well contained. For bond traders, the future appears to be safe, if perhaps a little dull. Yet, for bond investors who want to be sure they will have a safe pool of retirement funds, today’s calm masks a future that is far from certain.

At the moment, we are in calm waters. The Bank of Canada announced in mid-October it would leave its overnight rate at 4.25%. The U.S. Federal Reserve Board is holding steady at 5.25%, and bond markets around the world expect the global economy’s growth will subside enough to eliminate the need for major central banks to raise short-term rates. The interest rate trend is downward, bond prices have rallied — so what’s the problem?

There are two problems. The first is the so-called “elder bomb.” The second concerns asset valuation in 20 or more years.

Over the course of the next 35 years, baby boomers — born between the end of the Second World War and 1966 — will be moving from young old age (between ages 65 and 75) to middle old age (between ages 75 and 85). According to the 2005 federal budget, Canada’s population of people over 65 years of age will double by 2030. In that year, this age group will make up 40% of Canada’s population, 52% of Japan’s, 48% of Italy’s and only 31% of the U.S. population, thanks to high fertility rates among persons of Hispanic descent. By 2050, seniors will constitute 72% of Japan’s population, 68% of Italy’s and 44% of Canada’s.

Rising percentages of elderly people in national populations implies dependency ratios, the number of workers who support non-workers, will rise dramatically. Rising dependency ratios, in turn, imply that “pay as you go” social welfare plans will have to borrow from future generations. Long bonds are ideal for this purpose and, if governments want to match revenue and liabilities, they will finance their spending plans in proportion to the lifespans of the people who have to be supported.

A lot of money will have to be borrowed and the result will be higher interest rates. The theory that higher dependency rates will push up interest rates gains force when one considers trends in global development. According to Michael McHugh, vice president and portfolio manager of fixed-income at Dynamic Mutual Funds Ltd. in Toronto, rising disposable incomes in developing countries will put pressure on global prices. The Asian tigers and other countries will consume more and, therefore, have less money to park in U.S. treasury bonds, which are still the best game for storing and earning interest on trade surpluses.

“As developing nations invest in their own economies, they will reduce capital inflows to the U.S.,” McHugh says. The implication is the U.S. will have to raise interest rates to fund its huge trade deficit, which is growing by $900 billion a year. The Bank of Canada, which inevitably follows the U.S. over long periods, would follow suit.

One can argue that there are contrary trends; rising productivity, for example, will bring down product prices, with resulting increases in the real buying power of people around the world. As with the current China syndrome, which has pushed down the prices of industrial products — most notably, consumer durables — higher productivity would be disinflationary, argues Tom Czitron, managing director and head of fixed-income and structured products at Sceptre Investment Counsel Ltd. in Toronto. The implication is interest rates would decline over the long term, as they did in Victorian England, when industrialization and world trade reduced the cost of living and raised living standards.

The trend of interest rates will shape world capital markets for many decades in the 21st century. Debt finance would trump equity issuance if interest rates rose over time, increasing bond coupons and, eventually, their total returns. Stocks would beat bonds if rates fell. The elderly, supposed by some theorists to be eager to switch from risky stocks to less risky bonds, would be swayed by trends and opportunity, just like younger investors.

How should you play this complicated deck of possibilities? Nestor Theodorou, executive vice president and portfolio manager of fixed-income at Sarbit Asset Management Inc. in Winnipeg, says, “If you want to make a big bet on a trend, you can buy a 30-year strip. If interest rates fell by 1%, the strip would gain about 30% in market value. But it could go the other way if rates rise by 1%. Then, the strip would fall by about 30%. That’s why I don’t like to make big bets. In order to avoid the risk that inflation will erode your purchasing power, you can buy a real-return bond and accept its present yield of 4.2% based on continuation of the present inflation adjustment of 2.5%, which reflects recent gains in the consumer price index.”

@page_break@However, RRBs present challenges. They are a small subset of all Canadian bonds and are less liquid than conventional bonds. Therefore, they have wider bid/ask spreads than straight bonds. Thus, a retail investor who wants to trade RRBs is at a disadvantage.

Alternatively, the investor can buy a ladder of bonds and reinvest principal and interest as the bonds come due. Or, the investor can stay in cash equivalents such as T-bills and make no commitment at all. With the yield curve fairly flat, the ladder offers a chance to lock in returns rather than a step up to rising coupons over time. If rates rose from their relatively low level, one could roll into rising current yields.

“If I had to choose a single strategy, I would choose the ladder,” says Brad Bondy, director of research for Genus Capital Management Inc. in Vancouver. “If interest rates rise, you can reinvest at higher yields. You may suffer an opportunity loss on some bonds in the ladder before they mature, but at maturity, you get your money back. Or, you can let the government do index compensation for you via the RRB.” IE