Time to get out of bonds?

It’s often said that the bond bubble is about to burst. So why would anyone invest in them?

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(Peter Dazeley/Getty Images)

(Peter Dazeley/Getty Images)

Q: Would you advise getting out of bonds right now in favour of GICs?—Diane

A: Let’s start with why bonds may be risky right now, Diane. Bonds have an inverse relationship with interest rates. So as rates rise, bonds generally go down.

Imagine buying a $100 bond today maturing in 3 years’ time that pays 3% per year in interest. What happens if interest rates rise by 1% overnight? In theory, the bond will immediately drop by about 3% in value to about $97 on the open market.

The bond will still mature at $100 and in addition to paying 3% a year for the next 3 years, it will go up in value by about $1 or about 1% per year and effectively return about 4% a year annually for the next three years post-interest rate increase. The result is that the bond is paying about the same as a new bond issued tomorrow at the new higher market interest rate—also paying about 4% for the next 3 years.

So your return from the date of purchase to maturity would still be 3% per year. But you may experience a decline in price if interest rates rise prior to maturity. If you don’t sell and therefore hold to maturity, the decline is irrelevant.

I wanted to preface your question with an explanation as to why and how bonds go down in value, Diane. And to explain that the decline is typically not permanent. From there, you have to consider how the above-mentioned bond might compare to a GIC.

If you bought a GIC maturing in 3 years and paying 3% a year, it wouldn’t go down in value when interest rates rise—as GICs don’t trade on the open markets like bonds—and you would earn your 3% per year through maturity.

So if you had a choice between a bond and a GIC over 3 years and you were going to hold to maturity, you’re kind of indifferent between the two as long as they’re both paying 3%.

If you’re investing in bonds through a bond mutual fund, that’s where you have to be careful. Some bond funds have a mandate to hold longer term bonds that may include bonds maturing in 10, 20 or more years. A 1% rate increase will generally cause a loss of 10% on a 10-year bond and even bigger loses can arise on even longer term bonds, especially coupled with even higher interest rate increases.

So be very careful with bond funds, Diane. Make sure you understand what kind of bonds are contained within the fund and if the fund manager is forced to hold long-term bonds or if they have total flexibility with the holdings.

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Even if a bond fund manager has discretion with their maturities, I might opt for GICs over a lot of bond funds these days because reasonably conservative, high-quality bonds might only be paying 3% yields right now. If you’re paying the typical 1-2% bond fund management expense ratio (MER), that only leaves 1-2% net as your return. You can probably do better with a GIC. Bond fund fees are hard to justify currently unless you’re investing in riskier, higher yielding bonds.

On the flip-side, bond funds have an advantage over GICs because you can sell small portions of your fund if you need to get access to cash. GICs are generally locked in until maturity and can’t be severed.

So when assessing your choice of bonds versus GICs, you need to establish:

1)    If you’re considering a bond fund, if the yields are high enough to justify the fees;

2)    If you’re considering a bond fund, if the fund includes long-term bonds and if so, if the manager has discretion to move into shorter-term bonds;

3)    If you’re buying individual bonds, if you might need to sell before maturity and you’re risking a loss if rates rise in the interim;

4)    If you’re considering a GIC, if you can reasonably wait until maturity before needing all the funds;

5)    If the funds are in your TFSA or a non-registered account, if you’re better off paying down debt than investing;

6)    If investing in either bonds or GICs, if preferred shares are better from a tax perspective or if stocks are better from a risk/reward perspective.

So like many financial decisions, investing in bonds vs. GICs kind of depends. Consider all factors on your own or with your financial adviser. What you do with your fixed income is probably more important than what you do with your equities these days.

Jason Heath is a fee-only, advice-only Certified Financial Planner (CFP) at Objective Financial Partners Inc. in Toronto, Ontario. He does not sell any financial products whatsoever. 

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