How Not to Prepare for a Bear Market in Bonds

The risk of rising interest rates has become an obsession in the financial media. Those risks are undeniably real: it’s quite possible that broad-based bond funds will see multiple years with negative returns. (As I illustrated in a previous post, that would likely occur if rates across the yield curve rose 1% annually for three years. This article by Dan Hallett also includes some possible scenarios.) But these risks need to be kept in perspective: if you hold a bond fund with a duration shorter than your time horizon, your capital is not at risk. And if you’re a decade or two from tapping your portfolio, rising rates should even be welcomed.

And yet the bond bears just keep on roaring. The latest example is an advisor featured in a Globe and Mail article this weekend. “For the first time in my entire career,” he says, “bonds are in my opinion riskier than stocks.” He’s recommending his clients abandon the asset class altogether. Whenever articles like this are widely read, I get contacted by worried readers who are ready to follow suit. So here’s my preemptive response to what I believe is dreadful, dangerous advice.

This time isn’t different

To declare bonds are riskier than stocks is just another way of saying “this time it’s different,” long recognized as the four most dangerous words in investing. It’s also impossible to justify. Even if you’ve been investing for only five years you know stocks can lose 50% of their value in a matter of months. It’s inconceivable that a broad-based bond index fund could suffer a loss of that magnitude unless the Government of Canada defaults on its debt or we experience hyperinflation. A brutal scenario (the yield on 10-year bonds rises steadily from just under 3% to 6% or 7%) would likely see modestly negative returns over three to five years. To suggest investors can reduce their risk by allocating more to stocks and less to bonds is irresponsible.

Yet that’s exactly what the advisor is doing. For investors who currently have a target allocation of 60% stocks and 40% bonds, he’s suggesting a shift to 70% stocks. And what should they use for the other 30% of the portfolio? Market-linked GICs. Really?

If you need a refresher, a market-linked GIC guarantees the investor’s original principal over a specified period, often five years. But instead of paying interest, its returns are tied to the performance of the equity market (either an index or a portfolio of specific stocks). “If we have a rocking bull market, I think the upside is low double digits, and the downside is zero,” the adviser says.

But the downside is not zero. There is a real possibility of getting your principal returned with no return after five years. Meanwhile, you can find conventional five-year GICs paying a risk-free annual return of up to 3%. That’s an opportunity cost that can’t be ignored.

Dividend stocks less risky than bonds?

And what if market-linked GICs aren’t available? In that case the advisor suggests using dividend ETFs in place of bonds. Again, replacing bonds with stocks is presented as risk reduction: “I would respectfully say that in this unique context, I am actually taking risk off the table.” That’s an outrageous statement. Dividend stocks tend to be less volatile than the broad market, but not much. Let’s remember the iShares S&P/TSX Canadian Dividend Aristocrats (CDZ) fell in price more than 46% from September 2008 to March 2009. There is no reason to believe such a decline could not happen again. And there is no “unique context” where dividend stocks could possibly be considered less risky than a broad-based bond index fund, let alone a short-term bond fund or a ladder of GICs.

If you work with an advisor who suggests you should reduce your portfolio’s risk by exchanging bonds for stocks or market-linked GICs, I urge you to push back. If you’ve decided you simply can’t stomach the risk of short-term losses in an asset class that is supposed to be “safe,” that’s fine. But the solutions proposed by this advisor are, in my opinion, entirely inappropriate.

If you fear rising interest rates, the prudent strategy is to reduce the duration of your bond portfolio. That could mean using a short-term bond ETF or a ladder of GICs, both of which would allow you to benefit from an increase in rates. If you’re comfortable with a little credit risk, use short-term investment-grade corporate bonds to get a little more yield. Heck, move your fixed income allocation to cash if you really must. But once you go down the road of “this time it’s different,” you’re taking the first steps on a journey to a dark, unforgiving place.

55 Responses to How Not to Prepare for a Bear Market in Bonds

  1. Prasanna July 26, 2014 at 8:05 pm #

    ok great.thanks for the examples.

  2. mark January 1, 2015 at 3:34 pm #

    Just read a article challenging the decision of large allocation of bonds by this author.

    I think a GIC is more prudent at this point with interest rates poised to rise, at some point?
    Roll them over every year?

    http://www.moneygeek.ca/weblog/2013/06/01/open-challenge-canadian-couch-potato/

  3. HeKyLl January 7, 2015 at 6:19 pm #

    Mark, the MoneyGeek author was not opposed to “large allocation of bonds” per se. If you read the link you provided you’ll see that MoneyGeek was specifically opposed to keeping longer duration bonds. He thought that interest rates were going to rise and that the risk involved in holding them was no longer worth it. Also, although he was in favour of not keeping any bonds in your portfolio, he didn’t advocate that for everybody and so created 5 portfolios with various ratios of bonds to stocks which you would choose based on your comfort level.

    Here are two direct quotes from his post:

    “…our Portfolio 3 will deliver similar returns to that of the Canadian Couch Potato’s but at a lower risk, because our portfolios hold short term bonds.”

    “So there you have it. At best, in an unlikely scenario, XBB.TO will return 4.5%/year for the next 3 years. But more likely, it will earn just 2.35%/year or earn nothing, or worse.”

    His arguments sound rational…except he was wrong for 2014. According to the iShares website XBB’s total return for 1 yr was 8.46%. If you had followed his advice and switched to a shorter duration bond ETF (XSB), your total return for 2014 would have been 2.8%.

    Be sure to read his follow-up post where he tries to save face:

    http://www.moneygeek.ca/weblog/2014/07/31/whats-happening-canadian-bonds-xbb/

    This is precisely why I am a Couch Potato convert. If the MoneyGeek with his PhD cannot predict future bond returns with any accuracy, what hope do I have of doing so? He even had the nerve to say “Was I wrong? You decide.” Well, he *did* predict XBB was going to return 2.35% or worse….

    Mark, there are numerous articles on this website that address your question in depth. GICs are not liquid so you won’t be able to take advantage of rebalancing opportunities should something dramatic happen. Having said that, if you don’t like the way bond prices fall when interest rates go up then GICs will make you feel better — even though you don’t actually lose money if you hold a bond fund for the duration. Another strategy, discussed above, is to shorten the duration of your bond fund/ETF which makes them less sensitive to interest rate increases. However, as the MoneyGeek example shows, if interest rates don’t go up, the shorter term bond fund will have lower returns.

    Every time I hear “interest rates will go up in 2015” I think about how interest rates did not go up in 2014 despite all smart people who thought they would. I also think about what would have happened had I followed the advice that was being given at the time. The great thing about being a Couch Potato is I don’t have to think at all about all these predictions — I’ll stick with the plan and accept what the market gives me.

  4. Brian G January 7, 2015 at 7:41 pm #

    @HeKyLl, for fairness it should be emphasized that the MoneyGeek author only claimed that he would outperform over 3 years. Time will tell if he is right. No investment in stocks or bonds can be fairly evaluated in such a short time frame like 1 year. That said, he hides his portfolio behind a pay wall as far as I can see, so I doubt we can track it, so that is a point in favor of the transparent CP portfolio.

    Also, I have some bad news if you think XBB has gone up 8.5%. I claim it has lost about -1% over 2014.

    I make it a habit of measuring my investment return in CAD dollars, US dollars and a 50/50 mix. In US dollar terms, XBB has lost money over the year because the CAD dollar has lost about -10% over the year.

    I believe it is fair and wise to measure portfolio performance in US dollars because a lot the goods and commodities we consume are effectively priced in US dollars. E.g. food, energy, consumer goods, etc. Anybody who buys groceries knows that the real inflation for food is much higher than the official government CPI numbers! and much closer to tracking the CAD/USD exchange rate plus some inflation.

    I’ve wrote on here before that I don’t trust any one currency; especially a small currency like the Canadian dollar. Therefore, I don’t hedge and try to keep my portfolio mixed between currencies including my fixed income. I don’t try to predict exchange rates; instead when I add money to my investments I add it in equal parts between USD and CAD and never convert between USD and CAD again. This approach minimizes currency risk and provides some level of insurance in case CAD plummets or visa-versa. I’ve been doing this CAD/USD split for about 10 years and have seen it work in both directions and I just don’t worry about it… it’s just an insurance policy against currency devaluation which happens more often than one would imagine (E.g. in current years: Iceland, Japan, Russia, Venezuelan to name a few…)

    For the last few years, specifically, my fixed income allocation consists of a mix of XSB.TO and US Dollars (cash). In 2013, I looked at XBB and wasn’t comfortable with yield to duration vs. XSB. The risk just didn’t seem worth it. I looked at BND and SHY in the US but the yield curve is so flat that I didn’t like the risk return vs. plain old cash, so I stuck with cash. Given the current even flatter yield curves, I am even more convinced.

    This exceedingly conservative fixed income allocation has outperformed XBB in real terms of return/risk. I will be well positioned to buy longer term bonds or GICs when/if interest rates rise. Until them I am more than happy with my decisions and will be sticking with it this year.

  5. HeKyLl January 21, 2015 at 5:57 pm #

    The Bank of Canada announced an interest rate cut today (Jan. 21st). Yes, it’s still very early in the year but all the pundits who predicted interest rate hikes are probably shocked and awed right now.

    As mentioned elsewhere on this site, being a Couch Potato is very liberating. I imagine the consternation and frustration I could be going through right now trying to go through the exercise of predicting interest rates. In the end, if interest rates or the stock market change, up or down, I’ll just rebalance and stick to the plan.

    Mark, I don’t know if you ultimately followed the advice you were given but by following the Couch Potato strategy you don’t have the burden of trying to predict the future.

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