How can you cash in on stubbornly low bond yields?
High demand for Canadian bonds is keeping interest rates near zero. The question is: How long will bond prices stay this high?
The biggest bond owners in Canada are pension plans and life insurance companies. For them, high bond prices are a major problem.
Pension plans
Defined benefit pension plans buy bonds because they want to receive a steady stream of interest income so they can pay the monthly benefits they have promised to retired employees. Unfortunately, when bonds yields are really low, pension funds become seri- ously underfunded.
To solve the underfunding problem, a pension plan needs to collect more contributions from working members. It can also eliminate cost of living increases for retired members.
Life insurance
companies
Life insurance companies also own lots of bonds. Share prices of Canadian life insurance companies have been clobbered by declining bond yields, especially over the past five years.
Not many years ago when insurance companies set prices for policies, they thought they could count on interest rates up to 8.5 per cent to cover a significant part of the cost of insurance. Since interest rates seem to be staying low for longer than expected, life insurance companies have had to introduce double-digit increases in life insurance pre- miums over the past year.
Due to low interest rates, some companies have temporarily stopped selling new life insurance policies in Canada. Some have suspended sales of guaranteed minimum withdrawal benefit products.
Borrowers
Low bond yields mean low mortgage rates. It has been very easy to borrow money to buy a house.
When bond prices drop, higher mortgage rates will reduce demand for mortgages and houses, which, in turn, means house prices would drop or stop increasing. Costlier borrowing and house price declines would make real estate investment properties less attractive. If the supply of homes for sale increases, depressed prices would drop still further.
While bond prices continue to stay high, Finance Minister Jim Flaherty has decid- ed to cool off the overheated Canadian real estate market by announcing an end to 30year mortgages. This is the fourth time in four years the federal government has tightened mortgage rules. In 2006, Canada allowed 40-year mortgages, but has since scaled the maximum time frame back to 35 years, then 30 and finally back to 25 years.
The shorter-term amortization period for mortgages increases monthly payments for homeowners, which may prompt them to take on smaller home loans.
The government is rightly concerned that Canada’s very low borrowing costs are fuelling a housing bubble and pushing household debt to record highs. The Economist magazine says that average house prices in Canada are 19.8 per cent above their 2007 mark. The price-to-rent ratio indicates that Canadian properties are 76 per cent overvalued.
Pay down debt
When bond prices go down, interest rates go up. Carrying debt will become more expensive.
Now is the time to pay down debt. Do not wait until you are forced to sell something while you are under duress.
Short term bonds
How fast will bond prices drop? In the 1994 bond market crash, bond portfolios had losses of 20 per cent or more.
Long-term bond prices are very sensitive to economic changes. To protect yourself against losses, hold short-term bonds. If you own a bond mutual fund or preferred shares, which do not have maturity dates, ask your financial adviser about protecting your principal. Consider owning investments that have maturity dates.
Keep old policies
Think twice before you cash in a life insurance policy that has guaranteed lifetime premiums based on high interest rates.
If you are thinking about buying new life insurance, procrastination can be costly with prices increasing due to lowered interest rate assumptions. Terry McBride, a member of Advocis, works with Raymond James Ltd. The views of the author do not necessarily reflect those of RJL. Informa
tion is from sources believed reliable but cannot be guaranteed. This is provided for information only. Securities offered through Raymond James Ltd., member of the Canadian Investor Protection Fund. Financial planning and insurance offered through Raymond James Financial Planning Ltd., not a member of the Canadian Investor
Protection Fund.