OTTAWA – Bonds have long been the safe and steady ballast of an investment portfolio, but as interest rates appear set to rise, investment advisers say there are risks ahead.
Portfolio manager Brent Vandermeer of HollisWealth says it’s important for investors to understand how a bond works and how they are priced as the market faces a turning point.
“The average person does not understand that bonds could lose value for them,” he says.
“The opportunity for gains now that interest rates are at all-time lows is very small and yet there is a lot higher probability or chance for significant losses.”
Bonds are issued by companies and governments seeking to raise money. They include a promise to repay the principal at a future date as well as regular interest payments until then.
When interest rates fell during the financial crisis, the price of bonds that were issued before then climbed. That’s because those older bonds came with higher rates of return than newer bonds, which were issued at lower rates.
But investors now face the prospect of the opposite happening as interest rates appear set to start rising.
As expectations have increased that the U.S. Federal Reserve will start raising interest rates, bond yields have ticked higher and that means the same bond prices have headed south.
Sheldon Dong, manager of fixed income strategy at TD Wealth, says because interest rates have been falling for the past three decades, investors may be unfamiliar with that risk.
“What they have become accustomed to is capital appreciation in bonds,” he said.
“We’re not going to be in that situation going forward.”
In addition to the credit worthiness of the issuer, the price of a bond on the secondary market is determined by several factors including the interest it pays, its face value and its duration or how long it is until it matures and the issuer repays the amount borrowed.
The price of a bond moves in the opposite direction of its yield. As the yield rises, the price of a bond falls. That’s because as the interest paid by new bonds being issued increases, the price of bonds already issued will fall so that their yields will be more in line with those of the new bonds.
That doesn’t mean the amount the issuer must pay when a bond matures changes, but it does change the amount you will be able to sell a bond for in the secondary market if you need the money before the maturity date.
Advisers say that doesn’t mean bonds don’t have a place in a portfolio. It’s just important to understand the risks they carry and why you are holding them.
Investment adviser Kelly Gares of BlueShore Financial in West Vancouver, B.C., says one way to mitigate the risk of rising interest rates on bonds is to hold bonds that are close to their maturity date or ones with a short duration.
“Shorter term bonds with higher yields are less sensitive to interest rate changes and those really would be the ones you might want to focus on in a portfolio in order to kind of mitigate that effect of rising interest rates,” he says.
Gares says having a diverse mix of bonds is important.
“Right now, more than ever, having a diverse mix of different types of bonds is important,” he says.
And if interest rates do start to rise, that will mean good news for investors looking for income for the portfolios because it will mean that they don’t have to take on as much risk to obtain the same yield from their investments.
“For most savers, rising interest rates should not be feared,” Dong says. “It is a good thing.”