Times are hard for fixed-income investors. As of mid-January, a 10-year Government of Canada bond paid 4.05%, a 30-year Canadian paid 4.09% and a 90-day T-bill paid 4.17%. To top it off, the current yield inversion — which is pretty mild, as inversions go — is a road-sign warning that investors may not get paid for the risk of going long.

But this is nothing new, says Michael McHugh, vice president and portfolio manager at Dynamic Funds Management Ltd., who is in charge of $2.4 billion of fixed-
income assets. “Bond investors remain challenged by the low-yield environment,” he says. “If you thought yields were low in the late 1990s, when they were about 8% for 10-year Canada bonds, then you have to adjust your expectations now that rates are just 4%. We remain in a secular trend of declining yields.”

And despite this low-yield environment, McHugh believes it is all right to stick with bonds and customary allocations. “We remain in a favourable environment for investors to take some risk in the bond market,” he says. “We expect long-term bond returns to outperform cash over the next year. We think the 10-year Canada bond will earn 6%-6.5%, compared with cash, which will return about 4.25%.

“We are still in an environment in which investors can be assured of capital preservation by owning bonds and earning a better return than cash,” McHugh adds. “With investment horizons of equal length, bonds remain worth the risk.”

And if interest rates decline in response to a recession or investors’ falling inflationary expectations, long bonds will generate capital gains, McHugh says.

It’s also possible to boost returns by adding credit risk, of course, but the biggest risk in investment-grade bonds is duration.

Low-interest (a.k.a. low-coupon) bonds with long terms to maturity are intrinsically risky because it takes many years for investors to earn their money. For those who want to make a big bet on interest rates coming down, there’s an Ontario strip due June 2, 2031, with a 4.5% yield to maturity. If interest rates do fall, which is the belief of those who think the boom times are sure to end, there is a 24% profit to be made for every 1% drop in interest rates.

Of course, if it turns out that recent reports of low unemployment promise a continuation of good times and if theBank of Canadawere to raise interest rates to defend the Canadian dollar, for example, the outlook for strip investors would be grim — the same strip mentioned above would lose 24% in market price for each 1% rise in interest rates.

Long-duration bonds could generate capital gains, but the inves-tor has to take a lot of risk in buying and holding them. After all, with interest rates in the low single digits, there isn’t that much room for rates to fall.

As a result of this present environment, it is wise not to take excessive risk in long-duration bonds, says Brad Bondy, director of research at Genus Capital Management Inc. in Vancouver. “There is room in a portfolio for bonds, but one should go to the shorter part of the yield curve. I would stick to 10 years or less,” he says.

Under the Goldilocks scenario of gently falling short-term interest rates, the yield curve will steepen, Bondy explains. That means, he says, short bonds will outperform long bonds.

There are ways to get improved returns, Bondy says. “In comparison with relatively low returns in Canadian bonds, global bonds offer yield boosts. But the main gains are to be had on the currency side,” he says. “TSX equity returns and unhedged bond portfolios have low correlations. The TSX may go up this year, but the C$ is being sold off. Global bonds are likely to do better as just foreign currency plays.”

Bondy suggests that U.S. bonds have good value, noting that interest rates are higher in the U.S. than in Canada. “Ten-year Canada bonds yield 4.05% to maturity today; for the same term, U.S. treasuries pay 4.66% to maturity. Given good odds that the U.S. dollar may rise against the C$, the choice is to go with the U.S. bond,” he says.

There are, of course, ways to get good yields outside of bonds. High-dividend stocks compete on current return, although in a falling stock market, they would tend to suffer price erosion.

@page_break@So, is it worth taking that risk?

“Only if the investor can ride through a three-year downturn in the market,” Bondy says. “Individ-ual investors think they are long-term until the market turns bad. This raises the question of how long-term investors really are. There is a tendency to think long when markets are going up and short when they are going down.”

For risk-averse investors, bonds remain a good choice. “You should still hold bonds, but the purpose of bonds is no longer yield. It is just safety and balance,” says Adam Pion, senior client advisor at UBS Bank (Canada) in Vancouver, who advises reducing bond weightings. “If you are at 60% equity and 40% fixed-income, you could switch to 70% equity and 30% fixed-income. For the stocks, you want companies that have paid their dividends for many years and have a record of increasing their dividends.

“There are times to take corporate bond risk, but this is not one of them because spreads are too narrow,” Pion adds.

Risk control is the key. The Goldilocks soft landing is a possibility rather than a certainty. Thus, bonds continue to have a place in controlling portfolio risk, money managers agree; but with bond yields in a low range, the opportunity cost of that insurance is relatively high.

“People should underweight bonds and add to equity in dividend-paying stocks in stable companies. There is no free lunch in bonds or anywhere else,” says Tom Czitron, managing director of income and structured products at Sceptre Investment Counsel Ltd. in Toronto. “For cash flow, you’ll have to take more risk than in the past.” IE