PETER DOLEZAL: Are bonds a safety net?

Stock market volatility, world-wide, including Canada, recently returned with a vengeance

Stock market volatility, world-wide, including Canada, recently returned with a vengeance. Surprisingly, the trigger this time was a statement by the U.S. Federal Reserve Bank Chairman that the U.S. economy, doing better than expected, was well on the path to a solid recovery. This, he added, may cause the Central Bank to consider slowly withdrawing its current monetary stimulus, which to now, has involved monthly purchases of $85 billion in U.S. Bonds.

This announcement, which in the past would have propelled the stock market upward, instead caused world markets to swoon rather dramatically. At the same time, longer-term bond yields increased.

It may seem bizarre that equity market values had not previously reflected the inevitable withdrawal of this money-printing stimulus. Yet, those few words by the Fed Chairman had an immediate negative effect on stock markets.

Whenever significant short-term volatility hits equity markets, many investors begin to convert at least some equity holdings to bonds, which they perceive as the safer strategy.

Are they correct? Aside from the fact that trying to time equity markets by jumping in and out has repeatedly been proven a very unsuccessful strategy, those who switch to bonds often do so without fully comprehending that such a move may, for other reasons, be more risky than staying invested in equities.

When interest rates rise, as they have recently, bond values move in the opposite direction — they go down. The longer the duration-to-maturity of a bond, the more significant the downward price pressure. It is true that if an investor invests in individual bonds, rather than bond funds or ETFs, he can hold the bonds to maturity and receive the par value of the bond.

This can be a sound strategy — if the bond was bought by the investor at, or below, its par value ($100).

However, many bonds already held by investors, or newly bought today, have a purchase price significantly above the bond’s par value. This means that when the bond eventually matures, the investor will have booked a cumulative capital loss on his holding — the difference between the purchase price and the lower redemption, or par value.

The reason why? If, when the bond was purchased, its interest rate (coupon value) was above the market’s prevailing interest rate, the investor had to pay up front for that premium, by paying more than par value.

An example will illustrate. An Ontario Province Bond is available, maturing in June, 2019. It has an above-market coupon rate of 4.4 per cent. Because of this high yield, the purchaser would pay a price of $110 per bond. Compare this to its eventual redemption value in 2019 of $100 per bond. The difference is the investor’s capital loss, effectively lowering — dramatically — the bond’s actual yield-to-maturity.

Instead of considering the much lower effective yield-to-maturity, a bond investor is often drawn to a bond by its seemingly high interest rate.

The tax impact of this oversight can be even more costly if the bond is held in the investor’s non-registered account.

Using our same example in a non-registered account, the investor would pay his full marginal tax rate on the 4.4 per cent annual interest earned, despite actually receiving a much lower effective rate-to-maturity.

In the rising interest-rate environment which we appear to be entering, an investor opting to invest in bonds may be best to choose laddered bonds or bond funds with staggered maturities.

Other alternatives might be preferred share ETFs, some of which are now also available with laddered maturities.

Bonds and bond funds have their place, particularly in registered holdings. However, they are not an automatic replacement solution for equity holdings which experience periodic volatility.

Often, the best decision is to wait and watch — to ignore the volatility of a carefully-selected and balanced portfolio, and to await the inevitable upswing, back to a long-term growth track.

A retired corporate executive, enjoying post-retirement as an independent financial consultant, Peter Dolezal is the author of three books, including his most recent – The SMART CANADIAN WEALTH-BUILDER.