Bonds can help you cut your risk
It’s been a rocky year for Canadian stocks. As of the close of trading on Nov. 16, the S&P/TSX Composite Index was down 9 per cent for the year, due in large part to a plunge of more than 17 per cent in the energy sector.
It would take a huge, sustained rally to get us into the black by yearend. Don’t hold your breath.
By contrast, bonds are on the winning side of the ledger with the FTSE TMX Universe Bond Index ahead 1.87 per cent year to date. That may not look very exciting at first glance, but it is almost 11 percentage points better than the stock market. That’s a significant spread. Government bonds have done especially well, gaining 2.24 per cent for the year.
This bond outperformance should not come as a surprise. Back in January, I wrote in my Internet Wealth Builder newsletter that the global economy would be good news for government issues, which are seen as safe havens. At the time, I projected bond returns in the 3 to 4 per cent range. We’re short of that level, but at least we’re in positive territory.
At the same time, I wrote that Canadian stocks were in for a rough ride due to weakness in the energy sector and a likely retrenchment in financial stocks. Financials have in fact retreated by 4.5 per cent this year.
The point of all these numbers is that it is never a smart decision to downplay bonds in a portfolio, even when all the signs suggest interest rates are poised to rise. Economists have been projecting the death of the bond bull market for years but it hasn’t happened yet. Granted, the gains are much less this year than in 2014 but at least they are gains, not losses.
Bonds (or bond funds) provide an important element of stability for investors, especially in times of stock market volatility, such as we are experiencing now. The higher the proportion of bonds in your portfolio, the lower your downside risk when stock markets tank.
Using the year to date numbers from the TSX and the Universe Bond Index, a portfolio with an allocation of 75 per cent stocks and 25 per cent bonds would be down 6.3 per cent so far in 2015. If the allocation were 50-50, the loss would be 3.6 per cent. At 75 per cent bonds, 25 per cent stocks, the portfolio would be down only 0.8 per cent.
Clearly, the more risk-averse you are, the higher your bond weighting should be.
You can buy individual bonds through full-service brokers, although their inventory will be limited.
You can cross check the price you are quoted at candeal.com, which publishes bid-ask information on a wide range of government and corporate issues. If your dealer’s quote seems out of line, see if you can negotiate.
If you prefer to invest through funds, the cheapest option is bond ETFs.
The iShares Canadian Universe Bond Index ETF (TSX: XBB) has a management expense ratio of 0.33 per cent. The BMO Aggregate Bond Index ETF (TSX: ZAG) is even cheaper at 0.23 per cent but, surprisingly, its returns are less than the iShares competitor (4.2 per cent vs. 5.8 per cent for the year to Oct. 31).
The Vanguard Canadian Aggregate Bond Index ETF (TSX: VAB) is the cheapest of all with an MER of 0.14 per cent but it also has a lower re- turn than the iShares entry.
As these numbers show, the lowest price doesn’t necessarily translate into the best return.
There are also a number of focused bond ETFs available, including funds that specialize in provincial bonds, corporate bonds, discount bonds, short-term bonds, real return bonds, and global bonds. You can use these to provide some fixed income diversification within your portfolio.
The bottom line is that everyone should hold some bonds or bond funds. The weighting is up to you but keep in mind that the higher the bond percentage, the lower the overall downside risk. Gordon Pape is editor and publisher of the Internet Wealth Builder and Income Investor newsletters. His website is www.BuildingWealth.ca