The bond market: time for patience

With interest rates expected to rise again, many investors are about to make a singular discovery: bonds can also lose value.

When the stock market takes a beating, bond funds become more popular because their holdings are perceived as less risky. Last year provided the perfect illustration. In 2009 alone, Canadians responded cautiously by investing more than $11 billion in such funds.

And now they may well see a drop in the value of that investment! Here’s why.

Like a see-saw

Bonds belong to a category of investment vehicles with a somewhat misleading name: fixed-income securities. As the name indicates, these securities provide the investor with a predetermined income, as well as repayment of the capital at the specified maturity date. For example, a bond fund manager might buy government bonds maturing in 2013 and paying annual interest of 2.85%. What the name doesn’t tell you is that the value of those bonds can fluctuate, and changes in interest rates are one of the main factors causing the fluctuation.

Interest rates and bond values are like a see-saw: when one goes up, the other goes down.

Interest Rates and Bond Values

It’s really pretty simple. If interest rates go up, new bonds issued will also bear a higher rate. Which means that the bonds already in a fund, particularly those with maturity dates far in the future, become less valuable on the market, since they yield less than the newly issued bonds. As those older bonds lose value, it affects the performance of the fund that holds them.

No need to worry

Fluctuations on the bond market are generally much less dramatic than those on the stock market. And they are usually largely compensated by the interest income paid by some of the bonds in the portfolio and by the presence of corporate bonds, whose value tends to be linked to the balance sheet of the issuing company. Also, as a general rule, provided interest rates don’t start spiralling out of control, bond funds tend to recover as new bonds bearing higher returns gradually replace the older bonds as they mature.

Still, it’s good to know that such fluctuations occur. In 1994, for example, the Canadian bond market lost an average of more than 5% of its value. As the chart below illustrates, the bond market is a lot less stable than people imagine.

DEX Canadian Bond Index

What can you expect?

People who are hoping for robust returns on their bond funds this year would be wise to adjust their expectations and anticipate more modest performance, which is likely if interest rates start climbing. And those who were planning to cash in their bonds might want to plan their withdrawals keeping in mind the potential volatility of the bond market.

For a quick, if only approximate, picture of how investors might be affected, experts often calculate something called “bond duration,” which is the number of years it takes to recoup the cost of buying a bond. The idea is that the longer the average bond duration in a given fund, the greater the impact of rising interest rates on that fund. For example, if the average duration of a bond fund is four years, a 1% increase in the interest rate would result in an estimated 4% loss in value. So if the bonds in the fund are providing an income of 4%, the net return for that year would be… 0%.

The price of security

As we can see, when it comes to investing, there can be a cost to even the safest investments! Just remember that, as with stocks, the loss only becomes real if you dispose of your assets when the market is down. In other words, patience always pays off for the bond investor, too.

Still, with interest rates expected to rise, some investors might feel that now is a good time to review the bond component of their investment portfolio.