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Diversify as bond market is risky to predict

Diversify as bond market is risky to predict

January 9, 2014

The million dollar question these days is when will interest rates rise and how much that increase will cause bonds values to decrease.

While bonds are intended to be safe, their potential decline in value is of great concern. They are included in a portfolio to provide security against holding only stocks, which are more volatile.

We can start with a review of how bonds work. That is fairly simple. Then we will step outside the theoretical world and observe how bonds have actually performed in the past.

Governments and companies raise money by issuing bonds. Investors lend money to these issuers by purchasing these bonds. The bond issuer agrees to pay interest and at a future maturity date repay the full amount of the loan.

For example, you might lend the Government of Canada $10,000 by purchasing a government bond. They, in turn, agree to pay you interest every year, which in our example we will assume is 3 percent. In twenty years the government will repay the full amount of $10,000.

You can hold the bond until the twenty year maturity date or you can sell the bond on the open market. The potential problem comes with rising interest rates.

What happens if you lock in at an interest rate of three percent and one year later rates increase to four or five percent? Your bond will be less attractive and its value will decline. New bonds with a higher interest rate will be more desirable and sell at a higher price.

You will still get the full amount of the bond back after 20 years. During that time, however, your interest rate will be lower than other bond investors. As stated above, the current value of your bond will decline which is significant if you do sell it on the open market.

The longer the bond term, the more it will decline in value. Holding a poor interest rate bond for a long period is more damaging than holding it for a shorter time. Bond owners who are defensive against the potential of holding bonds during a period of rising interest rates will only buy bonds with shorter maturity dates; for example, less than five years.

It should be fairly simple to determine how to make a profit using the theory of how bonds work. Unfortunately, predicting the rise and fall of the bond markets is as elusive as predicting the future of stock markets. Experts do it all the time and often their predictions fail. When interest rates rise, bond values decrease. The opposite is also true; when rates fall, bond prices increase.

There have been four periods during the last 30 years where interest rates increased by more than 1.5 percentage points over a 12 month period. You might guess that during those times you would lose money owning bonds.

You might also guess that longer term bonds would have declined more than shorter term bonds.

Data made available by Barclays Bank for U.S. government bonds shows how actual market performance does not always follow the logic of what you might have predicted.

The two bond indices used are the Barclays Intermediate and the Barclays Long-Term. When examining intermediate and long- term bonds during the four separate periods of interest rate increases it is surprising that two of these four periods had better results for long-term bonds.

Of the eight different categories, seven had positive returns. The only loser was long-term bonds at the end of the 1970s when interest rates shot up by just over 15 percent.

If you look further into what affects bond prices you can get a glimpse into why long-term bonds did so well while interest rates increased.

The largest risk for bondholders is inflation. If you invest your money for 20 years and inflation erodes the true value of the dollar, then the true value of your bond at maturity is significantly worse.

Rising interest rates are a problem but the bigger problem is inflation. If higher interest rates help control inflation then that is ultimately better for the bondholder.

What should you do while most are predicting an increase in interest rates? Our recommendation is to diversify your portfolio based on your needs.

You cannot predict various markets so do not risk your money by attempting to do so. You can control how you balance your portfolio and that is your best strategy.