Interest-rate uncertainty unsettles bond investors

NOTE: This article has been edited from a previous version.

Like many bond investors, Dominic is on the fence.

The Toronto investor, who asked that his last name not be used, likes bonds because they provide a reliable, steady return, more than a GIC, but without the risk associated with stocks.

He estimates his return was about 5 or 6 per cent last year on his portfolio of corporate bonds.

But he’s not sure what to expect from interest rates this year.

“They’re talking about raising rates and then they hold back. I don’t know what’s to come.”

As a result, he’s wondering if he should make a move into dividend-paying stocks.

Experts say Dominic is likely not the only one.

Rising interest rates and falling prices, along with strong equity markets, may test bond investors this year.

“This may be the year when, like the black-clad villain in so many James Bond movies, investors say ‘Good-bye, Mr. Bond,’ ” Avery Shenfeld, chief economist at CIBC World Markets, quipped in early January when he delivered his 2011 outlook on markets.

Last year turned out to be a surprisingly good year for the bond market.

The start of 2010 began with much anticipation of interest-rate increases, which would typically send bond prices lower.

But as the economic recovery struggled to gain traction, those interest rate hikes didn’t materialize.

The benchmark DEX Universe Bond Index, which consists of investment-grade federal, provincial, corporate and municipal Canadian bonds, returned 6.36 per cent for 2010.

Experts say investors may see less than that this year.

At the same time, many investors who waited out the latest bear market and the recession in the bond market may be drawn to equities, particularly after last year’s surprisingly strong performance. Both the S&P/TSX Composite Index and Dow Jones Industrial Average posted double-digit returns on the year.

“Greed is a powerful factor. After a good year on the stock market, you see some flows into the stock market again. People are chasing returns,” says Patrick O’Toole, vice-president, global fixed income at CIBC Global Asset Management.

Still, most investors need to keep some fixed income in their investment portfolio, financial planning experts say.

Bonds, GICs (guaranteed income certificates) and other fixed-income products offer stability as stocks or equity investments fluctuate in value. Fixed-income is a buffer against risk.

“When people work with an advisor and they decide how much risk they’re willing to take on, that generally determines the amount of equities versus fixed income in the portfolio,” says Cameron Sievert, wealth advisor at Scotia McLeod.

“Bonds are a stabilizing factor in any portfolio. If you only have 10 per cent in your portfolio, it’s going to be much more aggressive than someone who has 50 per cent bonds and 50 per cent equities.”

The U.S. Federal Reserve and Bank of Canada have held their policy-setting interest rates at historic lows in a bid to cushion the recession’s devastating blow and revive the North American economy.

With the recovery gaining traction in Canada, many economists expect interest rates to rise later this year.

“Interest rates really have nowhere to go but up. That means bond prices will head down in 2011 and 2012,” Sievert says.

When interest rates are expected to rise, bond investors typically wait for new issues at higher interest rates, or yields, and do not choose from bonds in the secondary market.

That means prices in this market are likely to fall because of a glut of supply and corresponding weakening of demand.

“The existing bond may offer 3 per cent, but I know I can go out and get a new-issue bond at 4 per cent. So, I’m not going to pay you $100 for your 3 per cent. I might pay you $97,” Sievert says.

“That doesn’t really affect people in their portfolios, if they plan to hold the bond to maturity, but what happens is that people get their statements and sometimes they don’t understand how their bond can be valued at $97, when they were told by their advisor your principle is guaranteed.”

The bond will mature at the $100 par value, but values in the secondary market can fluctuate.

“The same thing happens in a falling-interest-rate environment. People have seen their existing bonds be worth $104, because new issues were coming out at lower interest rates.”

Does that mean bond investors should put off investing until rates go up, as expected, later this year?

“It’s hard to say because that’s a prediction on whether the Bank of Canada is going to raise rates and whether corporations and provinces will follow suit when they issue their debt,” Sievert says.

“The Bank of Canada may raise rates in the third or fourth quarter, but having said that, the Fed may not raise rates until 2012.”

That may send some bond investors looking for higher yields in corporate bonds.

Interest rates are unlikely to climb in the States, where unemployment is still high and the economic recovery is just beginning to gain traction.

But corporate profits are recovering, and, with the stock market expected to rise, corporate bonds may surge ahead of government issues.

“We still expect [both] positive returns and corporate bonds to outperform government bonds,” O’Toole says.

“Expect low single digits for government bonds and you might see in the 4-per-cent zone for corporate bonds, but we want to keep expectations in check.

“That’s lower than what folks are accustomed to.”