In my May 17 blog post “Are Bonds Really A Bad Investment?“, I made the following observation in response to a Warren Buffet quote on bonds being a bad investment:
“If you ever wake up in the morning and see Warren Buffett’s reflection in the mirror, then by all means only own stocks. If you don’t, then you should make your investment and asset allocation decisions based on your own personal risk capacity and risk tolerance.”
I stand by that comment even now as the debate over bond investing has actually increased with daily exclamations in the financial press on how interest rates are “spiking.” I have also seen several suggestions on how bonds have changed from a “low risk investment” to a “no return investment.”
The bond market is massive and has many moving parts, so the term “spike” is somewhat misleading. For example:
- Short-term interest rates, set by the Bank of Canada haven’t changed for years.
- If you are holding investments in high-interest savings accounts, the yields have stayed the same for the past couple of years as well.
- The yields on short-term Canadian bonds (1 to 3 years) have risen from 1% to about 1.3% since May.
After a thorough search, the closest thing I could find in the developed world that resembles a “spike”, is the yield on a 10 year US government bond, which has come close to doubling from about 1.6% in May to just under 3% now. Which isn’t a big move in absolute terms, but in percentage terms is quite large.
To put this in an investment perspective, here are some historical returns on some investable Canadian iShares Bond ETFs. Of note is the high volatility of longer-term bonds, which unfortunately some investors have realized can have stock-like volatility.
|Short-Term Bonds||Since May 1||1 Year||3 Years||5 Years|
|Short-Term Bonds (iShares XSB)||-1.03%||1.11%||2.05%||3.44%|
|Short & Long-Term Bonds|
|Bond Universe (iShares XBB)||-5.34%||-2.16%||3.15%||4.51%|
|Long-Term Bonds (iShares XLB)||-11.33%||-7.14%||4.42%||5.91%|
|Inflation Linked Bonds (iShares XRB)||-14.88%||-13.49%||2.48%||3.73%|
All Returns to September 13, 2013. Data Source: iShares.
The road to successful bond investing…
I get the sense, which may be skewed by the current media narrative, that people are scrambling to understand what they should be doing about “rising interest rates.”
Either reacting to recent short-term moves in the financial markets, using macro-economic forecasts on interest rates and/or trying to mimic the investment strategies of others, is out of touch with today’s reality. Put another way, this isn’t a repeatable, sustainable or consistent long-term strategy for investment success.
A better approach to investing…
Is one that incorporates a core philosophy, rather than a reaction to recent market moves. For bonds, it doesn’t rely on trying to forecast future interest rates, trying to predict what the central banks might or might not do or worrying about who the next head of the US Federal Reserve might be.
I am not advocating that you try to do this yourself, but here are five key points to consider.
- The decision to hold bonds in your portfolio should be based on your own personal financial goals, in conjunction with your own personal risk capacity and risk tolerance.
- The role of bonds in a portfolio should be to preserve principal, reduce volatility and/or to meet future liabilities. With that in mind, individual investors are best served keeping bond maturities shorter-term as longer-term bonds are too volatile.
- Risk and return are related. You don’t get a higher yield on bonds without taking on higher risk.
- There are two main factors that drive bond returns – term and credit spreads. What is nice about these two factors is that they are observable in current yield curves, so you don’t have to forecast changes in interest rates to be successful.
- On a risk/return basis it is better to take risk on the equity side of the portfolio, where the expected returns are higher than bonds.
Finally, it is important to remember that there are no such things as magic bonds … if interest rates go up, bond values will go down. The severity of the potential decline and the length of time to rebound in value depends on what strategy you are following.
How do you execute on a better approach to bond investing?
In order to execute successfully with any philosophy, you must use a systematic, consistent and scientific approach. An approach that automates the decision-making process and eliminates the behaviourial errors that can be very costly for all types of investors.
Remember, there is a science to successful fixed income investing, just like there is a science to equity investing and personal finance. To read more about how I personally came to use this approach with clients, please read The Science of Personal Finance.