With the global stock market performing as well as it has been over the last 16 months (MSCI All Country World Market Index USD was up 13.4% in 2012 and up 8.7% as of April 30, 2013), many investors are shying away from or reducing the amount of bonds in their portfolios.
Why is this happening? Is it a matter of overconfidence in the stock market? Is it the common mistake of “chasing performance”? – probably a combination of both.
The role of bonds, or other similar fixed income investments, should be for the sole purpose of limiting the volatility of the overall portfolio attributed to stock market fluctuations. That said, there are still risks inherent to investing in bonds. Before we discuss them in more detail, let’s review how a bond works.
A bond is a contract between a lender and a borrower. The borrower is obligated to pay the lender interest, usually on a consistent basis, and repay the principal at the end of the term. As a bond investor, you are the lender to the borrower (whether it is a government, corporation or individual).
One key risk to investing in bonds is the default risk. This simply is the risk attributed to the borrower’s inability to pay back 100% of the principal, due to financial issues. The greater the default risk, the greater the interest the lender should be provided. Generally speaking, governments have the greatest ability to repay the debt, therefore the interest provided on their bonds is low. Corporations or individuals generally can provide less of a payback guarantee than the government, therefore the interest rates are higher on their bond issues.
Another key risk to investing in bonds is the interest rate risk. Bond prices and interest rates are negatively correlated. More specifically, when interest rates rise, bond prices fall, and vice versa. An investor holding a 3% bond no longer has an attractive investment when interest rates rise to 4%. Therefore, the price of his bond (what people would be willing to pay for his bond) would drop in value. The rate at which bond prices rise or fall increase as the length of the bond contract increases. More simply put, the prices of shorter term bonds are less sensitive to interest rate fluctuation.
The current interest rate environment suggests that bonds are bad place to be. The world’s worst kept secret is that interest rates are going to rise. The only problem is nobody knows the time or magnitude of said increase. The biggest mistake would be to avoid bonds altogether. In 2009, the media talked of a “bond bubble”, stating that bonds were overpriced. Investors opting for cash, rather than investing in a diversified basket of bonds (DEX Universe Bond Index) over the past four years, would have given up a 20% return.
At The McClelland Financial Group, we continue to manage broadly diversified, balanced portfolios for our clients. We do not allow “noise”, be it from the media; friends; neighbours; cocktail party chatter; influence our clients’ long-term investment plans. Stocks and bonds, assuming a suitable asset mix, will continue to be the foundation of our clients’ investment strategies.
Source – United Financial; Death of Bonds
