Over the past few years there has been a flight out of equities and into government bonds. People fear the volatility that has plagued equities since 2008. This strategy appears to have worked. However, there is risk associated with this perception of a risk free investment.
Why is there risk when you are investing in government bonds, you may be asking? Let’s first look at what has happened with interest rates. The Bank of Canada web site shows us that the interest rate on 10-year government of Canada bonds has fallen from 3.1% in June 2011 to just 1.6% as of the end of July 2012. Falling interest rates are a positive influence for increasing bond prices. Here’s the caution. The same math that causes bond prices to increase in a falling interest rate environment will also cause bond prices to decline in value and suffer significant losses during a rising interest rate environment.
The greatest risk that bond investors face today is the risk of rising interest rates. This scenario is not only possible in the next few years, but it is highly probable. Hence, this is what we mean when we say that investors have shifted from risk free returns to return free risk.
The average interest rate on the 10-year government of Canada bond for the past 50 years has been 7%. Given today’s interest rate of 1.6%, the likelihood of interest rates rising is significant. We can’t say when it will begin or how high interest rates will rise, but it wouldn’t take much of an increase in interest rates for bond prices to decline in value by 10 to 30% as interest rates climb back up toward the long-term average.
In addition to the interest rate risk there are other risks associated with bond investing. With inflation running at about 2%, the bond investor is accepting a negative real return on their capital. If the money is not in a registered account such as a Registered Retirement Savings Plan (RRSP) or Tax Free Savings Account (TFSA), there will also be taxes to pay on the interest earned. This will further erode the negative real return on the bond investment.
Of course, there is the argument that bonds are guaranteed to return your capital in ten years. And you will receive a 1.6% return on your investment for the next ten years. The question to ask is how long you can sustain your retirement years on this type of return? An investment of $100,000 would yield $1,600 each year for the next ten years, and that does not include a deduction for tax. That might be enough money to buy groceries for one week per month for a retired couple. You would need $400,000 invested in your 10-year government bond, just to eat. What about your other living expenses?
If you are relying on your investments to provide or supplement your retirement lifestyle, you must look beyond bonds. There are alternatives. Take a closer look at equity prices. Try to eliminate the worries of Greece and Spain for just a few minutes. You will see that equity prices are cheap. Great, well-managed companies are rich with cash, and dividend yields are at historic highs. The dividend rates of many good companies are double or even triple the rate of 10-year government of Canada bonds. Yet equity prices continue to fall further every time there is another negative story about the woes of Europe.
Don’t follow the sheep. Do things differently. This could go down in history as the equity buying opportunity of the century. Don’t miss it.
The foregoing is for general information purposes and is the opinion of the writer. This information is not intended to provide personal advice including, without limitation, investment, financial, legal, accounting or tax advice. Please call or write to Rick Sutherland CLU, CFP, FDS, R.F.P., to discuss your particular circumstances or suggest a topic for future articles at 613-798-2421 or E-mail rick@invested-interest.ca. Mutual Funds provided through FundEX Investments Inc.