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Stocks down, bonds up means opportunity.

Investors have read many articles like Peter Hodson’s recent article in the National Post regarding further allocations to bonds. Certainly, with “interest rates of almost nothing”, the interest-only return from bonds is not what most investors will find acceptable if they are to meet their financial objectives.

But bonds contribute more to a portfolio than simple interest rate returns. As important as bond yield is the role bonds play as portfolio stabilizer that makes them such a valuable contributor to a portfolio. When stock markets correct, investors rush from stocks to the relative safety of bonds. Investor demand for bonds drives bond prices higher (and interest rates down even further) … and, voilà – capital gain. And investors still receive the usual bond income payments. (It works both ways. When stocks get an ‘all clear’ signal, there is a mad rush out of bonds and back into stocks).

According to the index returns calculator, DEX Universe bond index (XBB) returned 9.27% year-to-December 23, 2011. (While the S&P/TSX composite index (XIC) year-to-date returned 9.06%).

How can Universe bonds return 9.27% when interest rates are so low? Well, a good portion of the return is capital gain.

Each time investors are told ‘surely interest rates cannot decline any further’, yet another crisis panics the ‘hot money’ causing a mad rush to bonds. For long-term investors, however, bonds act like a hedge against ‘yet another crisis’. (Think: ‘Crisis insurance’). Until the next crisis, investors can continue to collect the usual bond income payments.

Does this mean that investors should buy bonds now? Rather than make a ‘bet’ on bonds, investors would be wise to hedge and continue to maintain some allocation to bonds (like the PIAC bond allocation, for example) and, when the next crisis side-swipes stock markets causing a mad rush to bonds, take advantage of the opportunity to rebalance some bonds (take profits, sell high) into stocks (buy low). Meanwhile sit back and collect the interest payments.

See also:  “Bonds? We don’t need no stinking bonds.” March 15, 2008.

Next time?  More Risk Management.
Doug Cronk CFA is Manager, Investments for a Canadian Pension Plan
3 Comments Post a comment
  1. John #

    Why did you not cite the source of the chart?


    December 28, 2011
    • Click on the chart and you will be redirected to the chart source.


      December 29, 2011

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  1. Hang on to your Bonds. | Institutional Investing for Individual Investors

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