Hang on to your Bonds.
Much of what is read in the financial press is telling investors to sell their bonds because interest rates are going up. Individual investors should look to what Institutional investors are doing and instead consider changing the composition of their bond allocation.
“Large losses are forever—in investing, teenage driving, and infidelity.” – Charles Ellis.
Why own bonds anyway?
We know bonds can play an important role in stabilizing an investment portfolio and at the same time delivering at least some income. Today, bonds should be relied on for defense over income. Despite low-interest rates the idea of diversifying a stock portfolio with bonds is still valid. Bonds will always cushion the volatility risk from stocks. In 2008 & 2009 investors saw equity risk dominate and downside stock volatility swamp any offset from a bond allocation. Usually bonds provide more of offset. Provide stability, deliver cash flow and moderate the volatility from stocks – that’s the purpose of bonds in a portfolio – they protect against large(r) losses. So we know we have to have bonds.
Not sure what to do?
You’re not alone.
It takes a disciplined investor to sort through the marketing and bias and come to some conclusion as to whether or not to sell bonds. The arguments for selling your bonds are nearly all based on the presumption that interest rates will one day go up. Indeed, short-term interest rates have moved up since year-end (long-term rates haven’t moved at all). But because we can’t predict future interest rate movements, we have to incorporate different views into our thinking. See here, here, here and here.
For those lacking discipline, they can always reference what Canada’s major pension plans are doing.
Are Institutional Investors selling their bond allocations?
The average Pension Plan in Canada per PIAC had about a 33% allocation to bonds. Larger Canadian Pension Plans still have significant bond allocations. CPP (32%) OTPP (48%) OMERS (34%) and BC IMC (32%), for example.
More likely, Institutional investors like Pension Plans are today adjusting the composition of their long-term strategic bond allocations. Those concerned about interest rates moving up may be shortening their duration (swapping longer-term bonds for shorter-term bonds). Others might be doing the opposite to make their bond holdings look more like their long-term liabilities. (The cash out-flows for pension plans are the pensions that have to be paid. Bonds have a similar but opposite cash in-flow. Thus assets are matched to look like liabilities). Some might add tactical bond bets like Emerging Market bonds. Some might move up the credit curve to try to capture additional yield from Corporate bonds (say) or High Yield bonds (God forbid).
The one thing Institutional investors are not doing is selling all their bonds.
What can Individual investors do?
For those concerned about higher interest rates, the simple plan would be to swap long bonds for short bonds. There are many, many choices to satisfy every investor from yield-hog to adrenaline-junkie. Use the tools below.
By the way, despite the sell your bonds noise, what are individual investors doing?
chart source: Alliance Bernstein.
Exchange Traded Fund (ETF) selection tools are of some help when sorting through the many, many bond ETF choices.
For U.S. listed bond ETFs, go to the IndexUniverse.com ETF selection tool and (At IndexUniverse.com select Fixed income under Asset class then de-select Leveraged, Inverse, and ETN’s. Voila. 174 to choose from.
iShares.ca has been the industry standard since inception and has many U.S. bond ETF choices.
VanguardCanada.ca provides only two bond ETF choices but boy are they inexpensive.
Bank of Montreal bond ETF’s offer even more choice and are worth a look.
_____________________________________________________________________________________Next time? More Risk Management. Doug Cronk, CFA is Manager, Investments for a Canadian Pension Plan