The real role of bonds in your portfolio

The real role of bonds in your portfolio

The role of bonds is not to deliver income or high returns, but to manage risk.

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With the bond market up about 3% year-to-date, the bears have been growling less than usual. But I still get a steady stream of email from readers who think bonds “make no sense anymore” because they have low yields and will fall in value if interest rates rise. However, if you’re a pension fund manager your opinion of bonds is probably different.

Before we go further, let’s acknowledge that a pension fund isn’t the same as your RRSP. Institutional investors have an indefinite time horizon, as well as access to far more investment options than you and me. Yet retail investors can learn a lot from the smart money like the managers of the Healthcare of Ontario Pension Plan. (Hat tip to Raymond Kerzérho, director of research at PWL Capital, for pointing me to the HOOPP strategy.)

It’s not about the income

HOOPP uses what it calls a “liability driven” investment approach, which involves constructing two separate portfolios with different goals. The first is the Return Seeking Portfolio, and it includes primarily Canadian and international equities, as well as a number of active strategies. The second is called the Liability Hedge Portfolio, and it is primarily made up of nominal bonds, real return bonds and direct-held real estate.

This latter portfolio is “designed to hedge the major risks of the liabilities—namely, inflation and interest rates—and utilizes assets which exhibit behavior similar to that of the Plan’s liabilities.” Notice what’s missing from that description: the word income.

Retail investors tend to think of bonds (and real estate, for that matter) as income investments. Many have abandoned investment-grade bonds in favor of high-yield bonds, dividend paying stocks and preferred shares because these alternatives offer higher yields, and potentially even higher total returns. But this misses the point. There’s a reason bonds are not in HOOPP’s Return Seeking Portfolio: their role is not to deliver income or high returns, but to manage risk.

Adding bonds to an equity portfolio lowers its overall volatility, but that’s not the kind of risk management were talking about here: after all, pension managers are not skittish retail investors, so volatility isn’t a big concern. They are more worried about the risk their fund will fail to meet its future liabilities. And one of the biggest sources of that risk is low interest rates.

Rising rates reduce your liabilities

Which brings us to the next insight. In the financial media, rising interest rates are presented in a relentlessly negative way. But if you’re a pension fund manager—or long-term investor who thinks like one—rising interest rates aren’t met with fear and loathing.

Pension funds estimate their future liabilities (the payouts they will make to retirees) using a discount rate based on the expected return of the fund’s assets. When the discount rate increases, the fund’s liabilities decrease, which is a good thing. But low interest rates on bonds lead to lower discount rates, which leaves pension funds with greater liabilities.

The point is that interest rates affect both sides of the investor’s balance sheet, which is why HOOPP manages that risk by holding bonds. As the managers write, “increases and decreases in the Plan’s pension liabilities are offset by gains and losses on the Liability Hedge Portfolio.”

In 2013, for example, the Liability Hedge Portfolio lost $1.44 billion in because a spike in interest rates drove down the prices of its bond holdings. However, those rising rates mean higher expected returns going forward, so the fund raised its discount rate by 25 basis points. As a result, its future liabilities fell by about $1.5 billion, more than offsetting the loss in the portfolio’s value. The opposite occurred in 2012, an outstanding year for bonds. That year the Liability Hedge Portfolio rose in value, but the fund managers had to lower their discount rate by 0.30%, which caused its future liabilities to increase.

The perspective of a pension fund manager can help you understand the role of bonds in your own portfolio. Yes, bonds have low yields and they will fall in price if rates go up. But HOOPP’s strategies can help you appreciate that they still belong in a balanced portfolio, and see rising rates as an opportunity rather than something to fear.

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