Fixed-income investments like bonds have a place in most portfolios. But they yield little as central banks have cut interest rates to soften the blow of the COVID-19 pandemic.
The coronavirus which causes COVID-19 is hurting economic growth worldwide. In order to soften the blow, most central banks that can still cut their interest rates have done so.
High-quality bonds and fixed-income investments have their place in most portfolios. At the same time, however, you should stay away from mutual funds of high-quality bonds.
Bonds are especially useful if you’re retired. That’s because you can line up your expected cash needs for the next five years and cover them with bonds that will mature when you’ll need the cash. That takes most of the risk out of your bonds. You can then invest the remaining cash in stocks for better long-term returns.
In a year’s time, your one-year bonds will mature. And your five-year bonds will have four years left to maturity, your four-year bonds, three years left and so on. At that point, you should invest the proceeds of the matured one-year bonds into new five-year bonds to meet your cash needs in five years’ time. That is, keep investing five years out on a rolling basis, year after year.
Bonds are like ‘ballast’ in your portfolio
Even if you’re still in your working years, bonds have their place. That’s because they give you stability. In that sense, they act like ballast in your portfolio and help balance it—just like real ballast helps balance a ship.
We recommend you stick with bonds of no more than five years to maturity. The small extra return you get from long term bonds simply doesn’t compensate for the risk of tying up your money for many years. As well, always invest in bonds with the intention of holding them to maturity.
We also recommend you stagger or ladder your maturity dates while in your working years. That is, invest in bonds that mature in each of the next one, two, three, four and five years. This will reduce your re-investment risk, or the problem of investing in bonds just as interest rates hit their bottom. Since you have money coming up for renewal each year, if rates rise you’ll benefit. If rates fall, at least most of your money will keep earning the older higher rates.
We’ve always recommended you stay away from bond funds. Our sister publication, Money Reporter, never includes bond funds among its top 40 funds.
The main drawback with buying bond funds is that you lose control. You can’t just line up maturities to fit your needs. You can only raise money by selling units in the fund. But do so at the wrong time and you’ll lose money. And you’ll pay management fees even if you lose money.
Government bond yields are pitiful
Recently, for instance, yields on most fixed-income investments have fallen. That has raised the prices of pre-existing bonds, which carry higher coupon rates. But invest new money into bonds today and you’ll earn pitiful yields. Government of Canada 10-year bonds yield only 0.53 per cent.
The recent fall in interest rates is no surprise. After all, most of the world’s central banks have cut their rates. They hope that ‘loose’ monetary policies will stimulate the global economy.
Most funds holding bonds will have recently made money. But bond fund managers can lose money with wrong bets, of course. We believe it’s best to seek gains in stocks—not bonds. At least stocks profit from the natural growth of the economy.
Keep in mind too that bonds have risen, with a few brief interruptions, since 1982. Back then, 20-year Government of Canada bonds yielded 18.6 per cent. It’s impossible to experience the same gains in government bond prices over the next 27 years. In fact, with interest rates at historic lows, there’s more room for them to to rise than to fall. Particularly if all the governments’ stimuli revive ‘galloping’ inflation. Climbing interest rates would inflict losses on bonds for many years to come.
When you invest in bonds yourself, you at least lose no money if you hold them to maturity. Even in a boom you’ll never hear a company’s management say: “Gee, since things are going so well, we’re going to pay the holders of our bonds more interest than they’re entitled to.” The fact is, the best a bondholder can hope for is timely interest payments and the return of his or her capital.
This is an edited version of an article that was originally published for subscribers in the March 20, 2020, issue of The Investment Reporter. You can profit from the award-winning advice subscribers receive regularly in The Investment Reporter.
The Investment Reporter, MPL Communications Inc.
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