Long term interest rates touched new lows this week, rewarding bond investors handsomely. However now that rates are at historic lows, many believe there’s only one way to go… up! Whether rates end up moving higher from here or not, the possibility of rising rates causes even savvy professionals to rethink the safety of their bond portfolios.
First, let’s review two bond basics. First, the relationship between bond prices and interest rates is like a see-saw. When interest rates go up bond prices go down, and when interest rates go down bond prices go up. Second, short term bonds and bonds that pay high coupons are more insulated from changes in interest rates than long term bonds and bonds with low coupons. Putting these two basics together, falling rates are kinder to long term bonds with low coupons, while rising rates are kinder to short term bonds with high coupons. Theory sounds good, but what does the evidence show?
According to a recent paper published by Martin Leibowitz, Anthony Bova, and Stanley Kogelman, it turns out that returns from bond investments have come almost exclusively from coupon payments over time, and not changes in price. That means a rising-rate cycle is not necessarily bad because bond investors can receive higher coupon payments that offset falling bond prices. An analysis of historic rising-rate environments supports this view, showing that a simple portfolio of five-year US government bonds performed surprisingly well when rates nearly tripled from 1966 to 1981, earning about 5.8% per year on average. That’s great news for bond investors!
Keep in mind that not all bonds are created equal. Since government bonds, corporate bonds, high yield bonds, and floating rate bonds each have different risk/return characteristics during an interest rate cycle, investors must pay attention to unique features of each asset class. Applying a systematic rules-based approach to the Canadian bond market can help provide consistent income in a rising rate environment with low risk.
Ben Kizemchuk is a Portfolio Manager & Investment Advisor with Altus Securities Inc. in Toronto. He offers financial planning and investment management for high net worth Canadian investors. Ben focuses on high quality investments, the Growth and Income Portfolios, low risk investing, and reducing tax.