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Poor performance from bonds likely to continue

by Wayne Cheveldayoff, 2006-05-25

Bonds have performed poorly so far this year and investors should expect more of the same for the rest of the year.

If a recession develops, bond prices will show gains as bond yields fall in the panic rush for safety, but the likelihood of that happening this year is very low, as the economy is showing strong momentum that won’t be easily disrupted.

The poor performance is evident in the returns of various bond funds. From January 1 to May 19, 2006, the Trimark Canadian Bond Fund (management expense ratio (MER) of 1.3 per cent annually) was down 1.01 per cent, according to Globefund.com.

Other examples: Altamira Bond Fund (MER 1.58 per cent) shed 2.86 per cent of its value in the same time frame; RBC Bond Fund (MER 1.47 per cent) fell by 0.97 per cent; and a fund with good long-term performance but which requires a minimum $25,000 investment, the Phillips, Hager & North Bond Fund (MER 0.59 per cent) had its value clipped by 0.30 per cent.

Specialized real return bond funds also took a hit, despite their better performance than regular bond funds in 2005. The TD Real Return Bond Fund (MER 1.48 per cent) dropped by 2.6 per cent year to date and the Dynamic Real Return Bond Fund (MER 1.8 per cent) was 3.69 per cent lower. Real return bonds pay a real yield, currently around 1.6 per cent, plus the rise in the CPI, but they obviously haven’t been able to escape the deteriorating trend for regular bonds.

High-yield bond funds put in a modestly better showing. The AGF Canadian High Yield Bond Fund (MER 1.95 per cent), which according to Globefund.com has a coveted five-star rating, was up a meager 0.94 per cent during the four-and-a-half-month period. The four-star-rated Investors Canadian High-Yield Income Fund (MER 2.29 per cent) was up only 0.33 per cent.

The management expenses charged by bond funds are obviously a drag on performance and investors can escape these by investing in bonds directly.

But it is impossible for anyone to achieve good performance from bonds when interest rates are rising. Nobody can escape the reality that as bond yields rise (stimulated by rising inflation expectations or by central banks pushing up short-term interest rates), bond prices go down.

Looking ahead, here is what would happen in a couple of cases – two-year and 30-year bonds – if bond yields rise another percentage point before the cycle turns.

The Government of Canada bond with a coupon of 4.25 per cent and maturing September 1, 2008 was priced at $100.25 per $100 face value at the close of trading on May 19. That produced a yield to maturity (combination of coupon of 4.25 annually and principal returned at face value at maturity) for the bond of 4.13 per cent.

If two-year yields rise another percentage point and this bond moves quickly to a yield of 5.13 per cent, its price will fall to $98.11 – a decline of 2.1 per cent.

Longer-term bonds are more volatile and the decline in price would be much greater. For example, the Government of Canada bonds with a coupon of 5 per cent and a maturity date of June 1, 2037 closed on May 19 at $111.10 (per face value of $100), for a yield to maturity of 4.34 per cent. If this yield to maturity was pushed up to 5.34 per cent in short order, the price of the bond would decline to $94.76 – a decline of 14.7 per cent.

For anyone who has witnessed how bonds performed in past inflation bouts driven by energy prices, bond yields appear to be unusually low in both Canada and the United States. With the North American economy still charging ahead, it looks like yields will still need to do more work on the upside to keep the wild inflation genie in the bottle.

Even if North American central banks stop raising their key lending rates this summer as some economists predict, it will likely only be a pause that refreshes for the economy.

There are good reasons to hold bonds in a portfolio, such as to provide income or balance out the risks of holding equities. Just don’t expect much performance from them in the months ahead.

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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©2006 Wayne Cheveldayoff