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Rising rates will punish investors with longer-term bonds and bond mutual funds

by Wayne Cheveldayoff, 2004-10-28

There are storm clouds on the horizon for investors with longer-term bonds and bond mutual funds in their portfolios.

Monetary authorities are likely to continue pushing up short-term interest rates and this will eventually feed through to higher longer-term rates, which will in turn reduce the value of longer-term bonds. It is just not clear at this point how bad the damage will be.

With bond prices having surprisingly rallied since June, this would be a good time for investors to take a good hard look with their advisors at their bond exposure. Bond returns have been quite good over the past 10 years as interest rates have fallen, but with the wind now blowing the other way, investors may want to take shelter from the coming storm.

Bond yields have fallen (and bond prices have risen) since June as bond traders have taken heart from the apparent tough stance against inflation taken by the Federal Reserve and Bank of Canada, both of which have been raising short-term interest rates.

But this optimism is likely misplaced. Oil-price-linked inflation is probably going to be worse, and the central-bank tightening more intense, than the market currently expects.

Things aren’t likely to get anywhere near as bad as the 1970s oil-price shock when interest rates ran to double digits. But just getting part of the way there will be damaging to bond prices.

Consider, for example, the latest economic forecast by the TD Bank economics group, which expects short-term rates to be pushed up from today’s 2.5 per cent to 4 per cent within a year and 4.75 per cent in two years.

What will this do for bonds? TD predicts the 5-year Canada bond yield will go from its current level of 3.8 per cent to 4.9 per cent in late 2005 and 5.65 per cent in late 2006.

This will mean a price drop, for example, for the Government of Canada 5.5 per cent bonds due June 1, 2009 from $107.08 to $102.43 in late 2005 and $99.39 in late 2006.

For the 10-year Canada bond, the TD forecasts a rise in yield from 4.45 per cent presently to 5.4 per cent in late 2005 and 6 per cent in late 2006, causing the price for the Government of Canada 5 per cent bonds due June 1, 2014 to drop from $104.27 to $97.03 in a year and $92.78 in two years – a decline of 6.9 per cent and 11 per cent, respectively.

If these bond-price declines occur as expected, there is no question that bond funds will also drop. Most bond funds maintain an average term to maturity of between 5 and 10 years, so there definitely would be some damage done.

Those holding longer-term strip (zero-coupon) bonds with the same yield would see a greater decline. The TD’s predicted rise in yields would cause a 10-year Canada strip to decline by 8.4 per cent in one year and 13.5 per cent in two years.

Investors can monitor what has happened to bond prices over the past five years by viewing the charts for the iUnits Government of Canada 5-year Bond Fund (TSX:XGV) and iUnits Government of Canada 10-year Bond Fund (TSX:XGX) at www.tse.ca.

These iUnit bond funds, with a management expense ratio (MER) of only 0.25 per cent, mirror the price action of the underlying Canada bonds. (More information on iUnits is available at www.iunits.com.)

Investors should all be applauding the Bank of Canada’s intention to prevent an escalation of inflation, which would cause even worse troubles for the economy down the road. But that doesn’t mean one has to stand in the way of a freight train.

Investors can take evasive action by reducing the term to maturity of their bond holdings to minimize the price damage from rising rates.

Or, if they think the Bank of Canada will not be able to contain inflation, they can investigate switching some of their RRSP bond holdings into real return bonds, which return a real yield plus the inflation rate. For those in mutual funds, Dynamic Mutual Funds recently launched a new real return bond fund, joining TD and Mackenzie with similar funds.

Wayne Cheveldayoff is a former investment advisor and professional financial planner. He is currently specializing in financial communications and investor relations at Wertheim + Co. in Toronto. His columns are archived at www.smartinvesting.ca and he can be contacted at wcheveldayoff@yahoo.ca.


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©2004 Wayne Cheveldayoff