Often thought of as risk-free, government bonds can pose considerable risk to your portfolio.
As they approach retirement, many investors believe they should hold a large proportion of their investment portfolio in bonds. We agree. But that’s not because it makes their portfolio especially safe. And it’s not simply for diversification. Rather, bonds make an excellent tool for planning reliable cash flow when you need it.
We call Government of Canada 90-day Treasury Bills the definitive risk-free investment. That’s partly because the impact of inflation over 90 days will be small. We can’t say that about longer-term bonds, even those issued by the federal government.
In fact, at times Government of Canada bonds can perform with as much price volatility as many common stocks. That’s especially true of the longer-term issues. Consequently, you ought not consider federal government bonds risk-free.
What is risk?
We define risk as the probability your money will be there — in cash — when you need it. In the case of a bond that matures long after you need the cash, the probability of being able to sell it with no loss of principal when you need money can also be low.
In general, risk in any security rises as the price rises. Bonds enjoyed falling interest rates over much of the last 40 years, until the last year or so. That means they enjoyed rising prices over those decades. But interest rates have risen dramatically from their historic lows in 2020. That has meant bond prices have fallen, causing the FTSE Canada Fixed Income Index to lose nearly 14 per cent of its value so far this year.
So there is definitely risk in buying bonds if you’re looking for trading opportunities. If, however, you buy only those bonds you plan to hold to maturity, they’ll do exactly what you expect — mature at 100 cents on the dollar and pay interest at the coupon rate every six months until then.
“But what”, you might ask, “if I live on the interest and when the bond matures, reinvestment opportunities provide a lower interest rate? Won’t I get a cut in retirement pay?”
The answer is not to live on the interest. Financial institutions such as insurance companies and pension funds match future liabilities with the maturity dates of bond holdings. This strategy, known as horizon matching, reduces the risk of getting stuck with long-duration bonds that lose value when interest rates rise.
Interest rates, of course, may settle down over the next year or so if central banks successfully bring inflation to bay. This may present a buying opportunity for bonds now, with the aim of making some capital gains over the next year or so. But no one knows for certain how long it will take to slay inflation, and how much interest rates may continue to climb before they come down again.
That’s why we advise investors take extra care not to get stuck holding a lot of fixed-income securities with long terms to maturity. If you have any qualms about holding any bond you buy to maturity, don’t buy it.
In an overall investment plan, estimate your future needs for cash at least five years into the future. Then, buy bonds, strips or compounding GICs that mature when you need the money. If you need, say, $40,000 each year, buy securities that mature at $40,000 at the start of each of the next five years. If you’re nervous about the investment environment, lengthen that — perhaps to as long as 10 years.
Then, invest the remainder of your portfolio in growth-oriented securities such as an index fund, or even dividend-paying stocks with dividend-reinvestment plans.
This is an edited version of an article that was originally published for subscribers in the November 18, 2022 issue of Money Reporter. You can profit from the award-winning advice subscribers receive regularly in Money Reporter.
Money Reporter, MPL Communications Inc.
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