It’s not time for bonds

Now is not the time to buy bonds, at least in Canada. To understand why, as well as the limitations of this perspective, let’s review how bonds react to changes in interest rates. Then we’ll look at prevailing rates. Finally, we’ll look at other income-producing options that may provide better investment opportunities at the present moment.

The Government of Canada, as well as agencies, provinces and corporations, issue new bonds regularly. The rate of interest offered on the bonds depends on the willingness of buyers to accept lower yields. For the federal government, whose credit rating is very strong, interest rates are the lowest in the country. For example, the average yield on 1-3 year Government of Canada bonds is currently under 1.5%. This is due to a “flight to safety” that happened during the stock market crash, increasing demand for government bonds, as well as reduced Bank of Canada interest rates. Agencies and provinces, with their strong credit ratings, will also pay low rates of interest. Corporations will pay interest rates that vary, depending on their credit rating.

Where can interest rates go from here? For the Government of Canada, rates can only go up. The Bank of Canada promised, in 2009, to keep their rate low until the middle of 2010. That time is rapidly approaching and signs of recovery and economic growth are becoming more apparent. It is highly likely that the Bank of Canada will start raising their rate, prompting investors to demand higher rates on their government bonds. New issues will come out at a higher rate, but how will older issues be affected?

If you own government bonds, you can expect to see the value drop (capital loss). When investors bought the bonds, they required a yield of only 2% (as an example). Suppose prevailing rates rise to 3%. In order for $100 worth of bonds, paying $2 per year, to offer a 3% return, the value of the bond will fall to $67. Now, $67 paying $2 per year provides a yield of 3%. If the investor wants to sell the bond, they will accept $67 for. However, if the bond is held to maturity, the government promises to repay the capital ($100), in which case there is no capital loss. The change in interest rates, however, causes the capital value of the bonds to fluctuate.

Government bonds are likely to lose value over the coming months and possibly years. Does that mean we shouldn’t buy any bonds? The answer is that there is more than one “interest rate”. Each organisation that issues bonds will pay a slightly different interest rate, depending on their credit rating (ability to pay in the future) and popularity (how much demand exists for their bonds). Corporations with a low credit rating (junk bonds) are required to pay a high rate of interest, or investors will have no interest in risking their funds. However, during the credit crisis of 2008-2009, these already high interest rates rose to extreme levels. Because the outlook was uncertain, investors (speculators) required very high premiums to own the bonds (promise to pay) of low-rated corporations, because of the possibility of bankruptcy. The spread, or difference in rates, is not constant. Although it has narrowed in recent months, it is still above the long-term average. While government bonds are almost guaranteed to face rising rates, the future is not so certain with lower-rated bonds. Base rates will indeed increase, but if spreads narrow at the same time, the interest rate on a corporate bond could remain constant or even fall, resulting in a (possible) capital gain.

Other securities react to interest rates in a similar way. Preferred shares are sometimes categorised as “fixed income”, because it is a promise to pay future income. There are differences with bonds, which I won’t elaborate here. However, preferred shares have behaved similarly to corporate bonds, by increasing in value while spreads decrease. Dividend-paying common shares have also delivered capital gains. Whether this is due to reduced demand for yield, increased expectation of future earnings or simply greater confidence in the stock market is impossible to determine. Realistically, all three factors, as well as others (such as cash flows) likely impacted share prices. But the result is similar to that of preferreds: capital gains and reduced current yield.

With government rates falling, buying government bonds would seem to be a foolish investment. Corporates or preferred shares, where spreads are narrowing, seem to offer a lower probability of capital loss. Dividend-paying common shares seem most likely to  produce capital gains, given the direction of the market and the distant relationship to prevailing interest rates.