By Jonathan Chevreau National Post FP Money Saturday, August 9, 2003

Few understand that when rates rise, bond prices fall.

The bond market meltdown of the last two months has been an unexpected shock for "balanced" investors who looked to bonds to offset stock market volatility.

The selloff has been a vivid reminder that being 100% in bonds is potentially as hazardous as owning only stocks.

While it's unclear that a 20-year "top" in the bond market was reached on June 13, the setback in bond prices has been the most severe since 1994. That was the last time investors were shocked to discover you can lose money in bonds and especially bond funds.

Bonds did rally a bit this week: prices recovered slightly as yields fell back. That inverse relationship is one of the least understood points about investing, a survey by Cartier Partners Financial Group found last fall.

Since the bear market in stocks started in 2000, interest rates have fallen steadily, which means bond prices have risen. With growing fears about deflation, bond investors were confident rates would remain low or fall more.

But the U.S. federal reserve sets only short-term rates, and at 1% it was clear they didn't have much room to fall more. With the economy and stocks showing renewed signs of life, long-suppressed fears of inflation and market forces caused yields for longer- term (10-year) bonds to start rising, so prices fell.

That's good for yield-starved retirees in money market funds or T-bills, since they'll get more interest. But it's bad for those locked into longer-term bonds.

"With U.S. interest rates having almost nowhere to go but up, the prognosis for medium- and long-term bond prices is not good," says advisor Leonard Hughes.

Apart from interest rates, bond prices are affected by term to maturity and ratings of credit quality. Investors should remind themselves why they bought bonds in the first place, says Hughes. "Was it for the milk [income stream] or the cow [principal]?"

Buying government bonds may starve you on the milk (yield) while corporate bonds expose you to credit risk on the cow (principal), Hughes says. That's why he likes professionally managed, diversified bond mutual funds. How bond funds add value is the current cover story in Fidelity Canada's Marketpulse.

For retail investors, guessing the future direction of interest rates is as futile as betting on the stock market's next move. Few are as prescient as Dow Theory Letter's Richard Russell, who sold bonds in mid-June and parked in treasury bills and gold. If you're as bearish as Martin Weiss (www.safemoneyreport.com), you'll stay in cash and wait for more carnage in the bond market.

Even professional bond managers, like Robert Featherby, are wary. "I don't think the worst is over yet," he says. In phase one, investors flocked to bonds because they felt the Fed was taking rates to zero. That phase is now over. The next threat is the Fed "may hike sooner than people think."

But Featherby doesn't believe radical changes are needed for those for whom bonds are just one part of a longer-term balanced investment strategy. That's in line with the stance of Cartier CEO Dan Richards: decide on your required long-term rate of return and appropriate asset allocation. Just as stocks should be broadly diversified, so should bonds be varied by term, issuer and credit quality.

Such plans require annual rebalancing. Investors who did so would have taken some profits in bonds and bought stocks in late 2002.

Vancouver-based advisor Adrian Mastracci at KCM Wealth Management suggests that bond funds are not bonds, so choose bond funds holding maturities between five and seven years. They should hold quality issues and the fund should sport low Management Expense Ratios (MERs). Hughes likes PH&N Bond (MER 0.52%) and Fidelity Canadian Bond Fund (MER 1.55%).

Investors oriented to the milk (income stream) can get more yield through corporate bonds or high-yield bond funds. The country's biggest such fund, Trimark Advantage Bond, recently closed to new investors but Hughes also likes Northwest Specialty High Yield Bond Fund, managed by Doug Knight. Its MER is 2.04%.

However, Andy Filipiuk disagrees with these advisors, suggesting investors with bond funds "get out now. Buy bonds yourself. You don't know what the manager is doing. He may be at the long end and getting shellacked."

The problem with bond funds, part from their fees, is they are in effect gigantic synthetic bonds which never mature. The same problem exists with the five- and 10-year bond exchange-traded funds (ETFs) of Barclays Global Investors, both of which fell back the last six weeks. University of Toronto professor Eric Kirzner suggests investors favour the five-year version over the 10-year.

If you own bonds directly through a broker, you avoid these problems, particularly if they are held in "ladders" of staggered maturities. Those holding strips (or bank GICs) maturing from one to five years have little to worry about provided they hold to maturity. A rise in yields is a chance to boost returns as old strips mature and are reinvested in higher-yielding ones.

"Sit tight on strip ladders," advises Filipiuk, "If stocks head south it's likely the bond market will rally in sympathy." If that happens, it's a chance to extend ladders 10 years out or more.

That strategy is favoured by Nathan Mechanic. He suggests investors hold corporate strip bonds as part of their bond portfolio. This week, yields between 6.25% and 7.2% could be found for terms of 10 to 20 years. Those issues don't last long in brokerage inventories, however.

Such investments, or regular bonds bearing interest twice a year, are appropriate in registered plans. Comparable yields may be found in tax-advantaged preferred shares for non-registered plans.

One advisor says those who think rates are falling should stick to conventional bonds. Those who think inflation (and interest rates) will rise should buy real return bonds (which rise with inflation) or move down the yield curve where the risk of rate hikes is lower.

"Undecideds might want to split the difference."

Aggressive investors could try income trusts, but only if they're willing to take on extra risk for the hoped for higher yield.

Warren Baldwin says, "bonds still belong in a portfolio," either through strip ladders or bond funds. But he doesn't recommend income trusts because they are high-yielding equities which subject investors to the same interest rate risk as bonds.

Ian Cubitt says those who expect a flat or deflationary outlook should hold 10% of their portfolio in the long end of the bond market, "even through the present downturn in prices." This hedges against a Japan-style deflation, Cubitt says. "You actually hope to lose money on your 10% long position because you should then be making up for it in the other 90% of your portfolio."

NOTE: The information provided above is intended for general informational purposes only. It does not constitute advice for anyone's specific situation. Everyone should always first consult directly with their advisors to determine the appropriateness of any information contained above before taking any action. KCM Wealth Management Inc. assumes no responsibility for any loss or damage arising from the use of, or reliance upon the above information.