The Long And Short On Bonds

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In any good investment portfolio it’s a good idea to have some bonds in it to help stabilize the volatility from stocks and equities. Bonds are a good way to ensure that stock market crashes don’t wipe out your entire investment portfolio. The reason for this is that bonds, in general, have a negative correlation to the stock market. That means when stocks go up, bonds go down and vice versa.

Take for instance the drop in the market following the Brexit vote this week. Despite the S&P dropping 3.6%, Canadian bonds actually went higher by 0.79%. Similarly during the stock market crash of 2008 US bonds actually went up 27.1% that year. You might wonder how bonds, one of the most conservative investment instruments can go up so much. Quite simple, just like stocks, bonds are traded on the open market just like stocks. When large institutional investors flee to safety, they think about buying bonds.

High Bond Prices

Over the last few years the flight to bonds have actually made them very expensive to own. Since the Federal banks of both Canada and the US have kept interest rates extremely low, bond prices have stayed relatively high. In fact, it wouldn’t be surprising right now to buy long term bonds that may actually have an overall yield of less than 2%. That’s how risk adverse everyone is 8 years after the stock market crashed.

There are those that say there is a bond bubble happening because bond prices are at an all time high. While this might be true because of volatility in the global economy, this still doesn’t mean that you shouldn’t be holding bonds in your investment portfolio. Despite the high prices, you should be aware that there are different kind of bonds. Some might be better to hold than others depending on the macroeconomic conditions and your own investment horizon.

Long Term Bonds

Bonds are considered long term bonds when they have a maturity date that is longer than 5 years. As an investment, long term bonds generally provide a higher interest rate than short term bonds, but at the caveat of being much more sensitive to interest rates.

The extra yield from long term bonds is because you are taking a risk by buying a bond that takes longer to expire. There are greater unknowns when the bond lasts 25 years because there could be hyper inflation, interest rate hikes and potentially insolvency of the issuing party.All of this creates higher risk, so investors will ultimately want a higher rate of return for their money.

With interest rates as low as they are, and quite frankly as low as it might get, long term bonds represents the greatest risk right now in a bond portfolio. That’s not to say that bond prices will collapse at any moment. There is still a lot of fear in the marketplace especially with the UK leaving the Euro and a general election in the US where Donald Trump can take things anywhere.

Short Term Bonds

Be definition, short term bonds are bonds that have a maturity of less than 5 years. With a shorter duration the risks become less because it’s easier to predict what might happen in the economy over the next few years.

Short term bonds are less likely to fluctuate in price as much because after 5 years the issuing entity will repay the face value of the bond back to the bondholder. It’s rare for the price to fluctuate far from the face value of the bond when an investor knows the bond will expire soon. Since shorter term bonds carry less price risk, the yields on short term bonds are generally lower than long term bonds.

Despite the lower risk, there is still the risk of the bond holder defaulting on the actual value of the bond and also the short term fluctuations that arise from market trading. This still leads to slightly higher yields on short term bonds over GICs, but not by much. If the yields were the same as a GIC, you wouldn’t want to buy the bond. From a common sense perspective, a GIC represents the least risk you can get since it is guaranteed that the principal is safe. Therefore, it would only make sense to buy a bond that has a higher interest rate to correlate with the higher risk.

Where To Find Bonds

When looking to invest in bonds, it’s probably best to use ETFs or mutual funds to create a diversified bond portfolio. It’s not hard to find a bond ETF that contains a variety of long and short term bonds that hold high quality bonds over a long duration. Take the Vanguard bond index fund (VAB):

vab_years

A typical bond fund will diversify between long and short term bonds. That’s because it is rare to find companies actually issue bonds that go up to 25 years. Those long term bonds generally represent government bonds of some sort.

A mutual fund like the TD Bond Index e-series or another ETF Bond Index by iShares (XQB) are also really good diversified bond indexes that will get you good exposure to Canadian bonds with low management fees.

There are also a few options for those looking for short term bonds and want less volatility due to interest rate hikes. There are no low fee mutual funds that target short term bonds only, but a couple of lower cost ETFs do exist.

xsq_years

Both the Vanguard (VSB) and iShares (XSQ) offer low cost short term bond ETFs that provide exposure to bonds that mature in less than 5 years. As the prospectus for the iShares fund shows, none of the bonds last for more than 5 years. Both ETFs have been recommend before for the Couch Potato portfolio and either would make a decent choice for those wanting to get shorter term bonds.

In The Portfolio

Some would question whether bonds are even necessary in an investment portfolio. I tend to say yes when it comes to this question only because investing is so emotional and bonds are the sort of thing that dampens the mood swings.

Some would argue that in a low interest environment that having GICs would be better than bonds because it has less risk but the same yield. I would disagree only because of the fact that you are getting that negative correlation to any equities you may hold. Bonds are still financial assets where the price can fluctuate. The principal of the GIC will never move and has no correlation to the movement of the stock market.

The question of how much bonds you should hold is something that is difficult to answer. If you are super conservative, holding more bonds is not the end of the world. If you can take more volatility and can sleep through nights where your portfolio drops 20% then perhaps less is better. At the end of the day, it’s really up to your own risk tolerance. What makes you the most comfortable. If you have any doubts, seek the advice of a financial adviser.

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