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Risk Management Series – Bonds

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Are Bonds Still Safe?

Investors have historically been told that bonds, while generally offering lower returns, are the safe portion of their investment portfolio. Over the past few months through mid-September, nearly all bond (fixed income) investors have lost money and in many cases these losses have been greater than 5%. So this raises the following questions: are bonds still a ‘safe’ investment? Why had they gone down recently? What do we expect in the future? Should they still be included in your portfolio?

What are Bonds?

Bonds are a contractual obligation by the borrower (issuer). The borrower (usually a government, government agency or corporation) agrees to pay a specified amount of interest (coupon) for a fixed period of time and to return the principal amount to the investor on the maturity date.

Why are bonds considered Safe Investments?

If you buy a bond issued by a financially strong company or government and you hold that bond until maturity, you nearly always make a positive return, as the bond issuer repays your principal (amount that you originally invested) AND interest. Bonds are considered safer than stocks, because all that has to happen for an investor to earn this positive return is that the company or government not go bankrupt, i.e. if the company is still an operating business on maturity date, the bondholders have to be paid their principal investment and their interest earned. Even in the event of a bankruptcy, bond holders often get paid in part or in full since bond investors have priority to the company’s assets.

Stocks by contrast are not a contractual obligation. Investors buy stock (equity) based on that company’s future earnings, i.e. the company’s ability to increase profits. If the company is unable to increase its net income (profits) over time, its stock is likely to decline in value.

Why have bonds gone down recently?

In between the date that a bond is issued and the date it matures, its price fluctuates based on a number of factors, including: interest rates, general economy, market sentiment and volatility, default risk, liquidity and for foreign bonds, changes in currency values. As a result, investors can earn more or less than the coupon amount (or even experience a loss) during periods of time in between the purchase date and maturity date of the bond. While the two main factors that typically affect bond prices are credit and interest rates (more will be discussed on these factors at the end of the article), the recent price decline has largely been a result of central bank policy, particularly quantitative easing.

iStock_000010237072XSmallQuantitative Easing – The Main Reason for the Recent Drop

Quantitative easing was initiated by the U.S. central bank, the Federal Reserve, as well as the European and Japanese central banks, amongst others, to help stimulate their economies following the Financial Crisis in 2008. These central banks, in addition to setting overnight interest rates near 0%, bought longer maturity government and mortgage bonds to increase money supply and flatten the yield curve. For example, since September 2012, the Federal Reserve has been purchasing $85 billion of longer-date U.S. treasury bonds and mortgage backed securities each month, which equates to over $1 trillion per year .

The aim of quantitative easing is to suppress interest rates for longer-dated bonds. This forces investors into riskier investments to earn a reasonable return, such as corporate bonds, equities and real estate and encourages businesses to invest and consumers to spend because of the low cost of credit. As a result, interest rates on 10 year bonds have been held near historic lows since 2009 and were between only 1.5% to 2.0% for most of the past year.

This changed in April 2013 when the Federal Reserve Chairman, Ben Bernanke and other officers started talking about tapering (reducing) these bond purchases, i.e. reducing and then eliminating the quantitative easing program. Investors feared that without the central bank as buyers that longer-term interest rates might go way up in the future, so many began to sell (i.e. if supply of bonds remains the same and demand (central bank purchases) goes down, yields go up). The interest rate on the 10 year US Treasury for example has gone from 1.62% in early May to 2.94% as of Friday, September 6th. Holders of those 10 year bonds have lost more than 10% during that three-month period as bond prices have gone down, i.e. for current 10 year bonds to move from a yield of 1.6% to 2.94%, their price must drop by over 10%. TriDelta’s own fixed income portfolios experienced losses during that period of 3.4% for Core and 4.7% for Pension.

What Do We Expect for the Future?

While we at TriDelta believe that interest rates are likely to go up in the future, we expect that this process will take much longer than most people believe, perhaps a number of years. We also believe that bond yields have gone up too high and too fast over the past six months. The performance of bonds over the past two weeks seems to back-up this view. The Federal Reserve decided on September 18th to not taper its quantitative easing program. Since then bond prices have gone up over 3% as reflected by the US 10 year bond. We at TriDelta believe there could be a further opportunity over the next number of months to generate more gains as bond yields continue to decline. We also believe that corporate and high yield bonds provide attractive returns as many of these companies are in a strong financial position with low overall level of debt and offer a premium yield to government bonds.

Why Include Bonds in an Investment Portfolio

In addition to being considered the safe part of the portfolio, bonds provide a reliable income stream and have a low and negative correlation with equity markets.* This means that if the equity market declines, bonds are likely to increase in value, providing downside protection for a portfolio. Investors often sell their equity holdings due to fear, these same investors buy bonds during these periods for security. By including bonds in a portfolio, they reduce overall volatility and often enhance overall returns. Lowering volatility also has the benefit of helping investors stick to their financial plan. While we do expect equity markets to be higher in the long-term, there will be periods where we could experience drops, bonds should help protect client portfolio values, enabling them to attain their investment goals.

*http://blogs.wsj.com/moneybeat/2013/09/06/rising-bond-yields-cast-shadow-over-equities/

 

Key Risks to Consider for Bonds in Normal Markets

Credit Risk reflects the potential that a bond could go into default, i.e. declare bankruptcy or issuer is unable to refinance. In that case, the investor would not be paid their interest and could lose some or all of their principal investment. This potential risk is reflected in the interest rate paid by the issuer. The higher the perceived credit risk (risk of a default), the higher the coupon (interest) rate. Typically, when the economy declines (recession) or growth slows, investors become more worried about the risk of default. Consequently, investors during those instances demand a higher interest rate (coupon) from corporate and high yield bond issuers.

Bond managers can often enhance returns by buying more corporate or high yield bonds when the economy is improving or growing and credit spreads decline and can protect returns by owning more government bonds when the economy is declining. Typically, government bonds pay the lowest interest rate as they are considered the lowest risk, then high quality corporations pay slightly higher, but still low rates, such as BCE, TransCanada Pipeline and the Royal Bank of Canada, with riskier companies, such as Barrick Gold Corpoation, paying a higher coupon.

Maturity Date / Interest Rate Risk – Bonds with longer maturity dates tend to pay a higher interest rate than those with shorter maturity dates. This is because there is more certainty in what will happen in the short-term, so investors are willing to accept a lower interest rate. In the longer-term, there is more uncertainty (will rates go up? will there be higher inflation?), so investors expect to be compensated with a higher interest rate to take on the risk of this greater uncertainty. When short-term interest rates increase as a result, yields on bonds go up (bond prices go down), but not in a uniform way. Yields on bonds with a longer maturity dates could go up more, meaning that their prices drop more. For example, if interest rates go up 1%, a 5 year bond will likely see its price drop by 4-5%, while a 10 year bond will likely see its price drop by 8-10%. The inverse happens when short-term interest rates go down – longer dated bonds prices go up more.

Portfolio Managers who can anticipate when short-term interest rates may rise or drop and adjust the maturity dates of their bond holdings to reflect their views, can enhance returns for their clients.

 

Lorne can be reached at lorne@tridelta.ca or by phone at (416) 733-3292 x 225.

Edward can be reached at edward@tridelta.ca or by phone at (416) 733-3292 x 229.

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