Yields are Low, but Bonds Still Have a Place in Portfolios
Bonds are an integral component of your portfolio that insulate it from the heightened volatility typical of equity investments and also provide a more reliable source of income. In other words, you seldom have to worry about a double-digit loss occurring the week before a regular or ad hoc withdrawal is required. If you believe that the primary goal of investment management is to preserve capital, as we do at T.E. Wealth, then an allocation to bonds continues to make sense for your portfolio.
Interest rate worries are especially prevalent because of the aging population in North America with many either approaching retirement or already retired. Many people are no longer in what we refer to as the wealth accumulation stage of their lives, but are withdrawing funds (or soon will be) from their investment portfolios to replace lost employment income. Industry statistics show a continuous flow of assets out of equity mutual funds into fixed income in Canada and the United States. We find it interesting that this persists given the paltry yields on these investments.
Low bond yields have been fodder for many an investment article or financial news segment of late. Rates are near 50-year lows, which has sparked debate as to whether it might be time to get out of bonds…entirely. The big question is how far and fast could rates conceivably rise? The Bank of Canada (BoC) has hinted that they might move ahead of the Fed, but it is unlikely they would do so in an aggressive manner. Meanwhile, the Fed has pledged that it will retain the current zero interest rate policy (ZIRP) until 2014… unless, we see a significant ramp up in inflation. However, deflation is truly the bigger concern. While commodity prices suggest we have inflation on our hands, wages and real estate [in the US in particular] suggest we are wrangling with deflationary demons, which puts a damper on overall prices and in turn, the general economy. Assuming deflation outpaces inflation until 2014, there is very little interest rate risk associated with bond investments. But, once rates actually start to rise this will translate into declines in the value of existing bond holdings. (Recall that there is an inverse relationship between the price of a bond and its yield.)
The media are devoting far more copy and airtime to the inflation angle of the story, but rates could actually go down further if we enter a deflationary cycle. Deleveraging is going to remain a drag on economic growth for an extended period of time and low growth rates (forecast at 2.1% in the US & 2.6% in Canada for 2012) are insufficient to offset the current degree of slack in those economies. And, while the likelihood of a Japan-style scenario is remote, this is precisely when bonds can afford you a good measure of portfolio protection.
It’s true that rising rates will hurt the bond component of your portfolio, but we still believe it makes sense to maintain an allocation to bonds through all market cycles. As with any well-diversified balanced portfolio, not every segment can advance at all times.
Steven Belchetz, MBA, CFA, President & Chief Investment Officer, T.E. Investment Counsel Inc.
June MacKinnon, CFA, Director of Research, T.E. Investment Counsel Inc.
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