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Part Two — Bonds: Why you should love the unloved investment

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Count bonds. Forget about sheep.

5-year chart comparing Canadian government bonds and the S&P/TSX 60

In the two years before the financial crisis, government bonds underperformed. Stock markets were hitting all-time highs and few investors were interested in bonds. However, as the risk premium for stocks was rising and stock indices in Canada and the U.S. were hitting highs, shrewd investors were reallocating their portfolios to include more bonds.

Bonds were unloved, but they were cheap, and when stock markets came down in a hurry, bonds acted like the buffers they are: they rose while stocks were coming down in portfolios.

The case for bonds in a portfolio as a permanent asset seems pretty solid. Let’s take a look at the last six months.

6-month chart comparing Canadian government bonds and the S&P TSX 60

Over the last six months, stocks have finally gone into a correction. Stocks have been incredibly buoyant since the bottom of the 2009 crisis and have performed very well. But corrections are a normal part of the investing landscape. Corrections are healthy since they clean out the speculative element in the market periodically. Investors, on the other hand, especially average investors, aren’t huge fans of volatility.

Looking at the chart over the last six months, we can see that government bonds turned up as the markets headed down. Bonds are doing what they do, once again: smoothing out returns by acting like insurance in your portfolio.

Equities hit home runs, but bonds keep you from crashing into the catcher’s mitt and getting called out at the plate.

Equities should outperform bonds in the next few years because bonds have made out well recently, but good diversification together with prudent asset allocation suggest the average investor should have some bonds in the asset mix. Recent news has shown us how commodities and stock markets can change direction in a hurry.

The debt situations in Europe and the U.S. illustrate the importance of having Canadian bonds in a diversified portfolio. Canadian bonds are in a good place when it comes to quality these days.  Just when many were saying Canadian bond returns had peaked and there was no future investing in them, boom, sovereign debt issues exploded in the media – again. Both recent history and the last few days are excellent reminders of why bonds have a place in the average investor’s portfolio.

Canadian government bonds may not work in a get-rich-quick scheme, yet when it comes to your portfolio, it pays to think. Think of bonds as insurance. Think of bonds before you go to sleep. In times of volatility, count bonds and forget about the sheep.

Part One is here.

Update: Foreign investors are also loving the unloved investment in Canada.

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Bonds: Why you should love the unloved investment

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Over the last couple of years bonds have been unloved. Interest rates have bottomed. Equities are historically cheap. The economy’s getting better.

Why debate any of the above? Surely, there’s some truth to these statements, and if you pay any attention to the financial news, you’ve heard them all.

Despite the lack of love for bonds, here are some reasons to hold bonds close to your heart through thick and thin, but especially through thin.

In 2009, when it seemed the earth had opened up and was swallowing investors and their portfolios whole, what did bonds do? They did what they’re supposed to do. Bonds acted like investment insurance. Bonds digested the increasingly bad news and turned that news into concrete returns. Interest rates plunged as governments moved to respond to economic fears, some rational, others less so.

Bonds or GICs?

How did bonds do vs. GICs?

The chart compares the Dex All Government Bond Index with 1-year GICs. Over three years, the bond index outperformed GICs by about 14 per cent. That’s roughly seven times the return. If you were invested in an ETF or a mutual fund holding Canadian government bonds, you would have made out well. And your investment would have been more liquid since GICs generally tie-up your money for the period you’ve agreed to invest for.

Stocks or bonds?

Bonds vs. equities

Over four years, if we compare bonds and stocks using the Dex Bond Index and the S&P TSX 60 Total Return Index, which includes dividends, we see that bonds outperformed. Of course, considering that the correction of 2009 was one of the deepest since the depression era, this isn’t much of a surprise. Bonds returned about 22 per cent while the S&P TSX 60 returned about three per cent over that period. It was an excellent period of outperformance for bonds.

The last few years, the financial media has been full of stories about why bonds won’t be the best of investments in the future. True. Bond prices are historically high at the moment, but every story should include that bonds tend to insure a portfolio – and they should always be part of a proper portfolio. Because they outperform, as demonstrated by the charts, when the stock market gets beaten down (see the financial crisis of 2009), bonds should always have their place in your portfolio.

No bonds? Your tolerance for risk had better be high. Bonds outperform when times are tough, and as bond assets rise they take some of the edge off the equities that are falling in your portfolio.

Why does this bond outperformance happen? Because during tough times, investors put their money in high quality investments like government bonds. Governments also tend to lower interest rates during times of financial turmoil. When interest rates go down, bonds become more valuable because the rates of interest they pay are more valuable when compared to new issues carrying lower interest rates. And that’s exactly what happened over the last four years. Bonds went from underperforming equities to outperforming them as jittery investors jumped into the asset class, and governments lowered interest rates in order to provide liquidity during the crisis.

Want to see a great infographic about bonds? (Somewhat U.S.-centric but still educational.)

111702-MINT-BOND

Stay tuned for Part Two.

Infographic: mint.com

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