Bonds are supposed to provide stability to portfolios. The theory is that in tough times, when stocks are falling, interest rates also tend to fall, which pushes up bond prices and breaks the fall of total portfolio values.

But what happens if inflation runs out of control, as it did in the 1970s? Yields on U.S. long-term government bonds rose to 14% in 1981 from 6% in 1973. At the same time, U.S. stocks — hammered by the 1973 Organization of Petroleum Exporting Countries’ oil embargo — went into a deep slump. The Dow Jones industrial average hovered below the 1,000 level for the whole decade, breaking out only after the U.S. Federal Reserve Board broke the back of inflation by pushing interest rates up. Rates rose in 1982 until AAA-rated corporate bonds yielded 15% and Canadian short-term bond rates reached 17.7%. The 1970s was a decade in which both stocks and bonds delivered terrible returns.

Can it happen again? On April 28, London’s Financial Times — noting the U.S. consumer price index was up 3.6% in the first quarter while gross domestic product grew just 1.3% in the same period — raised the possibility that the U.S. is sliding toward stagflation.

Worse, from a bond investor’s point of view, the mountainous U.S. foreign trade deficit threatens to drive up interest rates. There are al-ready murmurs in global finance that the process is underway.

A March 13 statement by China’s deputy central bank governor, Wu Xiaoling, that his country will use its massive trade surplus to continue to buy U.S. Treasury debt means there is much discussion that it won’t. Academic studies estimate that Chinese and other Asian central banks’ willingness to finance Americans’ tastes for inexpensive manufactured products has reduced long-term U.S. interest rates by 0.5%-2%.

Any motion by China to move away from U.S. T-bonds would have a devastating effect. If China and the Asian tigers decide to curtail their purchases of U.S. Treasury debt and shift their purchases to euro-denominated debt or British pound sterling-denominated debt, the U.S. would have to raise its interest rates to continue financing its bond sales.

Conventional bonds would decline in price. And Canadian real-return bonds and their U.S. cousins, Treasury inflation-protected securities, would post lower yields if Canada’s or the U.S.’s consumer price index stalled or fell. If the slump in the U.S. and Canadian economies were severe, stock markets would fall, taking down the equity component of convertible bonds already hit hard by rising interest rates.

But this situation would only be temporary, says Patty Croft, chief economist at Phillips Hager & North Investment Management Ltd. in Toronto: “Inflationary pressures in the U.S. would decline, lowering interest rates. So, that exogenous shock — China’s refusal to buy U.S. T-bonds — would only have a temporary effect.”

But before that recovery took place, some investors would find themselves in an abyss of red ink. The salvation of stock losses being made up by rising bond prices would not work. Balanced funds would be hit hard, as would investors planning to use RRSPs to buy annuities.

But there are solutions for this scenario. Michael McHugh, a portfolio manager at Dynamic Mutual Funds Ltd. in Toronto and a bond specialist with a long perspective on credit markets, says the problem of the decoupling of interest rates and price indices is far more complex: “If interest rates rise, there would be more volatility in bond prices. In that situation, we recommend investors go with bonds that will perform relatively well. These include short bonds, real-return bonds and convertibles.”

McHugh dismisses the traditional alternatives to rising rates and falling bond prices: shorting bonds, options strategies, laddered maturities and a bear fund that produces gains when bonds fall in price. His reasons are:

> Shorts are strong directional bets; moreover, they have negative carry. The seller of the short, who does not have the bond, does not get the interest. It’s a naked price play with no interest cushion.

> Options strategies are complex, require active management and are not for retail investors, he notes.

> Ladders don’t work well in volatile interest-rate environments. A good maturity one day may turn out to be wrong the next, he says.

> Bear funds are also directional bets. If you get the direction wrong, you lose.

@page_break@McHugh’s alternative, which he practises, is active bond management that can combine conventional bonds that appreciate when interest rates fall, real-return bonds that pay compensating gains when consumer prices rise, convertible bonds that rise in price as related stock prices rise and floating-rate bonds that neutralize the effects of specified interest rate moves.

Given the difficulty of predicting interest rates, diversification among bond products is the safest way to survive uncertainty. Chris Kresic, senior vice president for investments at Mackenzie Financial Corp. in Toronto, suggests clients hold their bonds in a blend of 40% core investment-grade credits, 20% short bonds with maturities of less than five years, 20% high-yield bonds, 15% real-return bonds and 5% global bonds.

Each subclass can work in a specific environment: conventional bonds for falling interest rates; shorts for stability; high yield for economic expansion; real-return bonds for inflationary periods; and global bonds for the boost foreign bonds get when underlying currencies rise in value.

The value of buying bonds gear-ed toward compensating for the divergence of interest rates and consumer prices depends on the probability of that situation happening. “We have concerns that countries with U.S.-dollar reserves will want to diversify their holdings, and that could cause the problem — driving interest rates up and consumer prices down,” says Aron Gampel, vice president and deputy chief economist at Bank of Nova Scotia.

A bond scenario fuelled by rising interest rates and falling consumer prices needs a safeguard. IE