I’ve been writing a lot about bonds lately:
- Basics of Investing in Bonds
- Understanding Real Return Bonds
- Understanding Corporate and High Yield Bonds
That’s why it was a “What’s on my radar” topic on Alberta Primetime this week.
There’s one recurring comment that stands out with me about the thought that the bond run is over and people should be shying away from bonds because of rising interest rates.
This speculation is concerning because bonds are not supposed to be a speculative asset class. Bonds are one of the three key asset classes in modern portfolio theory. Bonds should be an investment staple because they are key to diversification given their low correlation to stocks. I am getting these comments a lot so I thought I would share a bunch of issues to consider before you make broad generalizations to sell all your bonds.
Are interest rates going to rise?
Over the past 10 years, I’ve been asked to comment on whether interest rates will rise many times and it seems every time there is a concern that interest rates will rise, interest rates have gone down.
I’m not saying I know whether interest rates will rise or fall but I am saying that no one else knows whether interest rates will rise or fall either. You can’t control it and you can’t predict it.
Being a math guy, I think the probability of rate increases gets higher the longer interest rates don’t increase but at the same time, world monetary and economic policy has been to keep interest rates low partly because of record debt levels.
So even if interest rates do go up, the relevant questions are:
- How much?
- How fast?
At this stage in the game, direction may not be as important as magnitude and speed.
Rebalancing makes sense
I am a big fan of rebalancing portfolios and rebalancing out of strong performing asset classes into weaker ones. Although this can be tough to do emotionally, it is a logical way to practice buy low, sell high.
Rebalancing is a prudent strategy to take profits off your bonds and put them back into areas that have not done as well like stocks. Rebalancing does not mean selling all your bonds to buy stocks. That’s speculation.
Changing the types of bonds
There are many different ways to diversify your stock portfolio. You can diversify by geographic region, by sector, and by capitalization. In the bond world, you can also take diversification to a more sophisticated level. If you are concerned about rising interest rates, here are some ways to protect your bond component of the portfolio.
- Guarantee your capital with GICs. GICs and Bonds are very similar except that GICs are not valued daily and therefore does not fluctuate in value.
- Shorten the duration. When interest rates fluctuate, they affect longer term bond valuations more than shorter term bond valuations. In a rising interest rate environment, it’s safer to hold shorter term bonds
- Diversify your bonds. Another way to manage risk is to diversify your bond holdings into Real Return Bonds and Corporate Bonds. Although these bonds are affected by interest rate changes, their valuations are also influenced by other factors making them less correlated to conventional bonds.
The bottom line is to be careful of letting emotions and speculation lead you to imprudent investment behavior. There’s a good chance that everyone needs bonds in the portfolio to diversify and manage risk. The stock market will always be more volatile in both the ups and downs.