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.



Just Posted

Kay Gallivan paints a mural on the east wall of North Park’s Tiny Home Village (Kiernan Green / Victoria News Staff)
North Park Tiny Home Village opens at Royal Athletic Park lot to 30 unhoused

Residents will settle into new private units and the North Park community over the weekend

Carey Newman resigned from the Greater Victoria School District’s Indigenous Ad Hoc Committee May 13, citing ‘a pattern of systemic racism.’ (Black Press Media file photo)
‘Pattern of systemic racism’: SD61 Indigenous committee member resigns, calls for change

More than 350 people had added their names in support by midday Friday

The woman also received distracted driving tickets in 2018 and 2019. (Black Press File Photo)
Oak Bay driver gets third distracted driving ticket in four years

Officer caught the woman using her phone while at the wheel

Daily confirmed COVID-19 cases reported to B.C. public health, seven-day rolling average in white, to May 12, 2021. (B.C. Centre for Disease Control)
B.C. preparing ‘Restart 2.0’ from COVID-19 as June approaches

Daily infections fall below 500 Friday, down to 387 in hospital

Anyone with information on any of these individuals is asked to call 1-800-222-TIPS (8477) or visit the website for more information.
Greater Victoria Crime Stoppers wanted list for the week of May 11

Greater Victoria Crime Stoppers is seeking the public’s help in locating the… Continue reading

Sinikka Gay Elliott was reported missing on Salt Spring Island on Wednesday, May 12. (Courtesty Salt Spring RCMP)
MISSING: Salt Spring RCMP find woman’s car, still seek Island resident

Sinikka Gay Elliott is 5’3” with a slim build and dark brown short hair

A Saanich man received almost 10 years in Supreme Court in Courtenay for a shooting incident from 2018. Record file photo
Shooting incident on Island nets almost 10-year sentence

Saanich man was arrested without incident north of Courtenay in 2018

Bradley Priestap in an undated photo provided to the media some time in 2012 by the London Police Service.
Serial sex-offender acquitted of duct tape possession in B.C. provincial court

Ontario sex offender on long-term supervision order was found with one of many ‘rape kit’ items

Rich Coleman, who was responsible for the gaming file off and on from 2001 to 2013, was recalled after his initial testimony to the Cullen Commission last month. (Screenshot)
Coleman questioned over $460K transaction at River Rock during B.C. casinos inquiry

The longtime former Langley MLA was asked about 2011 interview on BC Almanac program

Steven Shearer, <em>Untitled. </em>(Dennis Ha/Courtesy of Steven Shearer)
Vancouver photographer’s billboards taken down after complaints about being ‘disturbing’

‘Context is everything’ when it comes to understanding these images, says visual art professor Catherine Heard

Most Read