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By David Baskin

If nothing else, the market crash of 2008 demonstrated the concept of risk to investors in a very dramatic fashion. When some equity portfolios fell 50% in a matter of ten weeks or so, even the most adventurous stock buyers became conservative. As the old saying goes, there are no atheists in fox holes. What is surprising is that many investors have stayed on the equity side lines long after the bombs have stopped falling and most of the smoke has cleared. Rather than going back into the stock market, they have bid up the prices of bonds and other supposedly safe instruments. Could they be inflating another bubble?

Three years ago the Government of Canada five year bond had a yield of 4.3%. Today it pays about 2.1%. When the Royal Bank sold preferred shares in early 2009 in the depths of the recession, it had to offer a dividend of 6.25%. These same shares now have a yield of only 3% to maturity. Good quality corporate bonds used to yield about 2% more than Government bonds with the same maturity. The spread has now come down to about 1.5%. Fear of volatility in the stock market has chased so much money into the bond and preferred share markets that prices have risen to what appear to us to be unrealistic levels. There is simply very little reward left in these markets – but there is risk.

Risk in bonds and preferred shares arises because interest rates change. If rates go up over the next few years, a bond that pays only 1.8% will be very unattractive, and its price will go down. Similarly a preferred share that only yields 3% will be competing with new ones that pay higher dividends and the price of the older security will fall. Of course, if one holds the bonds or preferred shares until maturity the market price does not matter much, but there is still a real loss, the loss of the opportunity to reinvest at higher rates before maturity.

With short interest rates in the US effectively at zero and still at less than 1% in Canada it is obvious that rates cannot fall much more. The chance of them rising is in our view very real. Rates rise when inflation rises or when the fear of future inflation becomes widespread. We have long believed that the huge deficits run up by the Federal government in the U.S. will inevitably lead to inflation there, and by a process of contagion, in Canada as well. We expect to see five year Canada bonds paying about 5% as soon as 2012, and ten year bonds will likely rise to over 7% by then.

The holder of a ten year Canada bond, which currently yields only 2.8%, would take a 25% price hit if that happens, and even a mixed portfolio of government and corporate bonds with a maturity equal to the bond index (about seven years) would take at least a 15% haircut. Preferred shares with long durations, and particularly perpetual preferred, would fall by similar amounts.

With this in mind we have kept our bond holdings to very short maturities, usually in the three to four year range. Similarly, most of our preferred share holdings are of the re-set variety, which will be called for redemption five years after the date of issue, mostly in 2013 and 2014. By doing this we have reduced interest rate risk to an acceptable level. However, for most clients prepared to take modest equity market risk we are much happier in this environment investing in solid dividend paying blue chip companies. The dividends are higher, in some cases much higher, than the yields available on bonds; the dividends tend to rise over time; and dividends get taxed at half the rate that interest attracts in non-registered accounts.

If our forecast proves accurate, there will be a time to invest in longer bonds, probably about two years from now. Until then, we will sacrifice some current yield to avoid capital depreciation in the future.

Source: Trouble for Bonds on the Horizon?