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Now is the time for bonds to shine as economy darkens

From Saturday's Globe and Mail

Saturday, February 24, 2007

If there's going to be an ideal moment to take cover in the bond market before the next downturn for stocks, it's now.

Share prices have been choppy after a long runup and many investors are overexposed to stocks, especially those in energy and mining. But there's an even better reason to put money in bonds than simple risk reduction. According to one money manager, now is the best time for investing in the fixed-income market since 1999.

The argument advanced by Randy LeClair, manager of the AIC Bond Fund, boils down to an opportunity to employ a "buy low" strategy in the bond market. If you own bond funds, you'll immediately understand what low means. Canadian bond funds lost 2.8 per cent in the first half of the year on average, and 1.42 per cent over the past 12 months.

The reason: Both the Bank of Canada and the U.S. Federal Reserve Board have been working to control inflation with a tighter monetary policy, which is econo-speak for raising interest rates.

Negative years are extremely rare in the bond market, and they're no doubt dismaying to investors who own bonds to add some stability to their portfolios. The good news, according to Mr. LeClair, is that the bond market has historically rebounded sharply in the aftermath of a series of interest rate increases.

"This is when you get the biggest bang for your buck in bonds, in the year following a tightening phase," he said.

There are numbers to back this up. The only two losing years since 1980 for the Scotia Capital Universe Bond Index, the standard gauge for measuring bond market performance in Canada, were 1994, with a decline of 4.3 per cent, and 1999, with a decline of 1.1 per cent. The index rebounded in 1995 with a gain of 20.7 per cent, and in 2000 with a jump of 10.3 per cent.

The index needn't have gone into the red for there to be a big payoff in the year following a series of rate increases by the central bank. After the index returned 4 per cent in a tightening phase in 1987, it jumped 9.8 per cent in 1988.

Mr. LeClair's outlook hinges on the expectation that central banks have either finished raising rates, or they're close to done. His rough and ready estimate of bond fund returns for the next 12 months: 6.5 to 7 per cent. "I tend to be a little conservative on my estimates -- it might be a little better than that."

David Adamo, Scotia Capital's head of fixed-income research, has also noted a tendency for the bond market to rally -- bond prices rising and yields falling -- after a cycle of central bank rate increases.

This time, he thinks it's possible that the yield on 10-year Government of Canada bonds could fall from the current level around 4.37 per cent to the area of 3.75 per cent, which is near the 12-month low reached last summer. This view suggests a reprieve is coming for investors whose fixed-income holdings were hammered in the past year or so.

"My take is that if the Fed feels comfortable enough with the inflation picture that it's going to stop raising rates, then bondholders should feel comfortable in buying," Mr. Adamo said.

While Mr. LeClair foresees a solid bond market rally ahead, the longer-term prospects for bonds could be similar to what we've seen in the past few years. Sheldon Dong, vice-president of fixed-income strategy at TD Waterhouse, sees bond yields ranging between 3.5 and 5.5 per cent for the next 10 years.

"People aren't going to get rich buying bonds," he said. "That's my No. 1 premise. Don't expect big capital gains. Buy bonds because you need them for insurance."

That's the long-term view. In the next 12 months, it may in fact be possible to generate returns from bonds not only through the interest they pay, or the coupon in technical terms, but also through capital gains. If you buy a bond today and rates fall, then the price will rise and you'd have a capital gain by selling the bond at a profit.

This is tough for small investors to do, in part because they often have to pay premium prices for bonds. An easier approach is to use a bond fund, where the manager can shuffle his or her portfolio to capitalize on opportunities to generate capital gains.

You'll see what the manager can add in Mr. LeClair's estimate that his fund would return 6.5 to 7 per cent this year. The longest-term bond there is, the 30-year Government of Canada bond, yields only 4.45 per cent or so right now, so the additional return would have to come from capital gains generated by Mr. LeClair.

Bond funds are justifiably ripped from time to time because a lot of them charge unacceptably high fees. But if you can find a fund with reasonable fees, then it would certainly be a viable way to play a declining rate environment to your advantage.

If you prefer to buy individual bonds, the thinking from several fixed-income strategists right now is to stick with government bonds and to go long in term.

The yield curve today is relatively flat, which means that there's only a benefit of roughly 0.3 of a percentage point between the yield on a two-year bond and a 30-year bond. This raises a question: Why lock your money in for the long term when you can get almost the same return from something that matures in a year or two.

The answer is that interest rates are widely thought to be at or near a peak, and that they could well start to ease later this year and into 2007. Someone who buys a bond maturing in a year will likely have to buy a replacement at lower rates. With a long bond, you eliminate this risk and add some yield certainty to your portfolio.

Mr. Dong of TD Waterhouse said long bonds can also help limit the risk of a portfolio heavily exposed to stocks.

"If people are overweight the resources or they're looking for a hedge for their equity portfolios, by all means look at a 10-year or 20-year Government of Canada bond as an insurance policy."

Government bonds look better than corporates right now because of where we are in the economic cycle, Mr. Dong added. Corporate bonds have done quite well in the past few years, but slowing growth would make them less attractive.

With the equity markets strong in the past few years and bonds coming off a bad year, some investors are bound to have neglected fixed income in favour of stocks. Mr. Dong says investors have also been forsaking bonds for income trusts, which generate higher yields than bonds in almost all cases.

"That's a danger," he said. "People forget that at the end of the day, these income trusts are small companies for the most part, and they haven't gone through a cyclical downturn in a long time."

If you want to ease back on trusts, take profits from stocks or just reduce the risk level in your portfolio, bonds work. Plus, now's an ideal time to buy.

The four ways

How to get bonds into your portfolio:

1. Bond funds

Pro: The easiest way for the investing masses to get bonds into their portfolio because all mutual fund companies offer them.

Con: Many bond funds have high fees that cut too deeply into their returns.

More info: Globefund.com

2. Bond ETFs

Pro: Exchange-traded funds tied to bond indexes offer much lower fees than bond mutual funds, so their returns should be competitive.

Con: You need a brokerage account to buy them.

More info: iShares.ca, Globefund.com

3. Owning bonds directly

Pro: No fees to own them, unlike bond funds and bond ETFs, and you have a lot of flexibility to choose the term and yield.

Con: You need a brokerage account, and small investors often don't get the best deals when they buy bonds.

More info: Contact an investment adviser or discount brokerage.

4. Strip bonds

Pro: Ideal for the registered accounts of people who don't need income (instead of paying interest, strips are bought at a discount to the amount they pay out at maturity).

Con: In non-registered accounts, you're expected to pay taxes annually on strips even though you receive no interest payments.

More info: Contact an investment adviser or discount brokerage.

Bond funds to bond with

Here's a list of Canadian bond funds with lower-than-average fees and well above average returns over the five and 10 years to June 30.

SOURCE: GLOBEADVISOR.COM