Or should you be even more cautious?
Canadian bonds have been on a tear these past few weeks. Yes, bond prices climb as yields fall, and the Bank of Canada’s surprise interest rate cut on Jan. 14 helped goose Canadian bond prices. In fact, a good proxy for the Canadian bond market, the iShares Canadian Bond Index ETF (TSX: XBB), is up 3.5% since the beginning of the year so far, following an 8.5% gain in 2014. But this doesn’t mean you should run out and pack your RRSP with Canadian bonds, bond mutual funds, or ETFs. On the contrary, it might well be a time for heightened caution.
How bond pricing works
Where extra risk now comes into play is in that inverse price/yield relationship of bonds. Once issued, bonds are traded in an informal (albeit very large) market. And because of the inverse relationship of a bond’s price to interest rates, bond prices rise when rates fall, but also a bond’s price will fall if general interest rates rise. (It’s a complicated mathematical relationship that essentially keeps a bond’s yield competitive in the marketplace.)
High-quality government bonds will always pay the stated coupon rate, which is based on the face, or par, value of the bond. What you actually receive is the “yield” of the bond based on the price you pay. So if you paid the face value (usually stated as “$100”) on a bond that carries a 2% coupon rate, your yield will be 2%, or $2 per $100 of face value. But if you paid something other than face value, your “yield” will be either higher or lower than the coupon rate. To make matters even more complicated, money managers use a complex calculation called the “yield to maturity,” which involves the bond’s par (or “face”) value, its market price, its stated interest rate, and the time left to maturity, and assuming that interest payments are reinvested at the bond’s current yield.
Rate risk and capital loss
When analysts talk about interest rate risk, they’re not referring to whether or not the bond will pay its interest. They’re referring to the bond’s price. If rates rise, the price of your bond may fall below your purchase price, resulting in a capital loss if you sell your bond before maturity.
In actively managed bond portfolios, such as those you’ll find in fixed-income mutual funds, managers will adjust their holdings in an effort to mitigate interest rate risk. They do this in various ways, including tilting bond holdings to longer or shorter maturities, or investing in bonds with different risk ratings, in different regions or countries, or attempting to anticipate interest rate moves – all depending on the mandate of the fund as set out in its prospectus. Some funds can be quite successful at this, as seen in the recent Fundata FundGrade A+ Rating 2014 award winners.
Many exchange-traded bond funds (ETFs) are also available, and their MERs are generally lower than for fixed-income mutual funds. Bond ETFs usually aren’t actively managed, and they are available in many configurations, including those that track short- and long-term indexes, as well as indexes of government bonds, corporate bonds, all bonds, laddered maturities, and so on. But on the minus side of the equation, they will reliably track their underlying index, no matter which way it goes, including down. It can get complicated.
Shifting allocations now can be dangerous
In general, investing in fixed-income assets can be just as complex as investing in equities, sometimes even more so. If you already have a diversified fixed-income allocation in your RRSP portfolio, which is designed to match your objectives and risk tolerance, it probably doesn’t make a lot of sense to start shifting allocations more to Canadian fixed income in the hope of capturing further upside. That strategy suffers from two failings: 1) you’d be attempting to time the market to capture the right entry point, something that even the professionals cannot do consistently; and 2) you’re speculating on another cut in interest rates to drive prices even higher – which may or may not happen.
If you’re confused about how bonds work and the best type of fixed-income investment to include in your RRSP, I’d suggest consulting a qualified financial advisor. But do it soon. The final day for making your 2014 RRSP contribution is March 2, 2015.
© 2015 by Robyn K. Thompson. All rights reserved. Reproduction without permission is prohibited.–