If you invested in a bond fund to avoid drama, the recent rise in yields may have you wondering where in the FinPipe you went wrong.

Perhaps your first mistake was to assume that any investment is completely safe.

Bonds are less risky than equities, because when things go sideways, bonds get paid out first. That makes them safe by comparison, but not exactly risk-free. They just have more protection to counter their lower returns.

But bonds also come with a price risk: As yields and interest rates go up, the price of existing bonds goes down.

Why do bonds lose value?

Everything in the bond market is driven off the government credit curve, or the rate at which people would be willing to lend money to the Government of Canada.

That curve isn’t static. The government is constantly borrowing money from different players and that means the market moves and adapts, so the rate at which Canada can borrow money at changes every day.

The government borrows money by issuing bonds, which once issued, can be traded. Those bonds and those trades create a market, where many bonds with different coupons live. A bond’s coupon is the percentage of interest paid on that bond over the course of a year.

When you plot exactly what the cost would be for Canada to borrow money at each point in time (based on all the bonds that were issued) a yield curve – which is basically a graph detailing the yields-to maturity of all kinds of all outstanding Government of Canada bonds.

But again, that graph isn’t static. The prices of these bonds will change based on things like Canada’s credit quality and where people think inflation is going.

If it looks like inflation will go up, people are less likely to want to hold bonds, so the government of Canada will have to pay a higher interest rate to convince people to hold bonds.

And when rates go up, the yields people are demanding go higher. Bond prices fall – and so does the value of a bond fund.

Why do interest rates have to rise?

Whether interest rates rise or fall is partly up to each country’s government. Governments can set a funding rate for banks at a level that they choose, but the only rate in the bond market that they have any control over is the overnight rate, or the rate at which regular banks can borrow money from the Bank of Canada on an overnight basis. The market dictates everything else.

After nearly a decade of historically low rates, central banks moved in 2017-2018 to normalize rates, or bring them to a more historically accurate level.

What that level is exactly is a matter of some debate. Thirty years ago, mortgages came with interest of 15 per cent, while in 2018; homebuyers are accessing funding at 3 per cent.

While the general consensus is that interest rates are going to move higher over time, how long that will take or exactly how high they’ll rise is anybody’s guess.

What does this mean for your bond portfolio?

For people holding bonds, all these shifts in interest rates and monetary policy mean trades will come with a price risk.

Let’s say you bought a 10-year bond at $100 with a 1.5 per cent coupon. That bond promises to pay you $1.50 a year for each of the 10 years you hold it – that’s its yield, or yield-to-maturity.

A day later, interest rates jump to 3 per cent. That means anyone buying a 10-year bond for $100 will now get $3 a year.

You locked into a contract that still only pays you $1.50 year, because that’s where rates were at when you agreed to buy your bond.

You’re not pleased.

You’re free to buy new bonds at 3 per cent and get your $3 a year, but if you want to convince anyone to buy your 1.5 per cent bond, you’ll have to sell it for less than the original $100 to make up for its lower return.

If the bond you have can’t give your buyers the yield they’re after, they’ll want to buy it at a discount, which means you’ll have to sell it for less money than you paid for it.

If you decide to just hold your bonds to maturity, however, you’ll still get what you were promised when the bond matures. But you’ll miss out on the chance to take advance of higher coupons.

What you can do

One way investors can protect themselves from rising rates is to buy shorter-term bonds. These have smaller price swings than long-term bonds because they have a shorter duration. Duration is used as a measure of a portfolio’s sensitivity to a change in interest rates.

That’s also why floating rate bonds can be a good option to ride out a rising yield storm.

Floating rate bonds have a duration of only 3 months (the shortest you can find), with a coupon that resets every three months.

There’s less upside when things go well, but the shorter duration also means less risk.

If you think you can’t stomach any turbulence, you can of course get out of the bond market altogether.

But it’s important to understand that no investment is completely risk-free, and while some may be more nerve-wracking than others, it’s never a good idea to react out of anger or panic when things aren’t going your way.

It’s usually worthwhile to take a step back and try to understand why the bond market is acting the way it is.

2 years ago