Home » Bonds » Bonds in a Low Interest Rate Environment (Part 2)

Bonds in a Low Interest Rate Environment (Part 2)

Now that you are well armed with information on bonds, in today’s environment, why would you buy them?6870875029_14b5890993_q

For many Savers, the decision to hold bonds right now is based on a belief in continued stagnant interest rates or as a deflationary hedge. Think about how low interest rates are today. They really can’t get much lower. However, it could be that our low rates are going to stick around for a while yet. If that’s the case, then bonds will continue to provide a deflationary hedge and most likely, a small return. Our friend at the Bank of Canada Stephen Poloz recently advertised: “… there is a growing consensus that interest rates will still be lower than we were accustomed to in the past”.

Depending on the types of bonds that you buy, you might be able to make the ride a lot less rough as interest rates rise. One method of reducing interest rate risk is by reducing the duration on the bond fund. With rates so low to begin with, the difference in yield to maturity between a broad bond index fund and a short term duration fund is only 1% right now. (XSB at 1.58% vs XBB 2.50%) As explained on Dan’s blog on bonds and interest rates, if interest rates rise by 1% per year for three years, a short term bond fund will be in the black whereas a board index fund will be in the red.

Another option includes looking for products like floating rate bonds or floating rate notes where they reset their interest payout to reflect changing market conditions. Most of these products return less than short term duration funds but if interest rates do go up, they will weather the changes better.

Lastly, you could consider using a bond ladder instead of holding a bond fund. Just like with a GIC ladder you would hold individual bonds that mature at regular intervals. For example, every year for the next 5 years. When the bonds for next year mature, then you buy bonds for 5 years out. The advantage is that bonds that are held to maturity don’t lose value. The drawback is that there is liquidity risk, if you cash out early any paper losses would need to be realized. The other problem with a bond ladder is the lack of diversification. This exposes you to default risk which is especially important if you are not investing in only the highest grade bonds.

But why should you really hold bonds?

The reasons above may be enough to convince you that holding at least some of your portfolio in bonds is a good idea. However, you shouldn’t be thinking about market timing when you’re purchasing investments and most of the suggestions above are reactions to our current market conditions. What you should be thinking about is your investment time horizon and your risk level in order to determine your ideal asset allocation. I know, such a boring text book answer! As always, there are good reasons for this.

  1. Consider the financial crisis of 2008. If you were holding long term bonds when the market crashed you would have had a cushion of 8% or so from a broad bond ETF to help offset the unpleasantness. If you were holding short term bonds, floating rate notes, or junk bonds you wouldn’t have benefited at all. The purpose of bonds is to soften out the volatility of the equity market. Sometimes it’s a beautiful thing. Now consider our current circumstances of all-time highs on many indexes. Just like 2008, if the market were to correct, you exposure to bonds would soften the blow. As icing on the cake, bonds tend to trend in the opposite direction of equities. So if the market does tank, potentially your bond fund will increase. Of course, the inverse is also true. If the market is heading up, then interest rates may follow and bonds will decline in value.
  2. Bonds provide safe income. Though the income available from very safe bonds these days is quite low, so is the inflation rate. If you hold on to your bonds for the duration (either holding bonds individually or through a fund) then you’ll receive the yield advertised.
  3. You shouldn’t time the market. Ultimately it comes down to this one basic principle. As an individual investor you won’t be able to out think the market. You don’t know how long the low interest rates will last and you don’t know when the next market correction will be. Maintaining your asset allocation correctly is the single most important factor in long-term success.

If you’re looking for more information on bonds, check out, Part 1 Bonds in a Low Interest Rate Environment.

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  1. I really like it when individuals come together and
    share ideas. Great blog, continue the good work!

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