Investors own bond funds for three reasons.
The first reason is to benefit from the income they produce, which provides them with additional funds for spending in retirement or for savings.
The second reason is to hopefully sell their investment at a later date at a profit, which in turn will provide them with a capital gain, which is taxed at a lower rate than simple interest income. This strategy works great in a declining interest rate environment which we have experienced over the past decade until recently, when yields dropped so low they really have nowhere else to go but up.
Finally, having less volatile bonds (as compared to stocks) in ones portfolio can help smooth out overall fluctuations and help make it easier to stay the course during rocky times in the equity markets.
Unfortunately, the recent changes in the economy, massive government printing of dollars and billions of dollars in stimulus have led to the decrease in the value of the dollar and led to historically low interest rates.
In the past, 10-year U.S. bonds yielded returns in excess of 14% (back in the 1980), over 6% in 2000, over 3% in 2010, to as low as .7% last year. The massive printing of money and the economic activity it is trying to generate is likely to lead to renewed inflation and higher interest rates going forward. Since bond prices move in an inverse direction to interest rates, not only is this bad for investors hoping to earn a capital gains on their bond investments, but it is actually beginning to generate negative returns in many bond funds.
So what can bond investors do to protect themselves in this environment?
They can increase their equity weightings, which many have clearly done. This in part has contributed to equity indexes hitting all time highs recently. However, this may also expose investors to more risk than they are comfortable with. Having money in sash, GIC’s or guaranteed investments is another much safer option.
Other alternatives include using high yield, corporate or emerging market bonds. However, these higher yields come with much greater volatility, which investors typically do not expect from their “safe” bond investments.
They can also invest in funds in which the managers use lower durations (the maturity period) or maintain a lower credit risk rating for greater stability. Finally, they can diversify their debt holdings by investing in inflation protected bonds which are also called TIPS or Real Return Bonds which unlike traditional bond,s enjoy increasing yields during rising inflation.
While some of the above may be too technical for the average investor, one area that they can control is the mer’s (management expense ratios or fees) that they are paying for professional management.
Unless your manager is providing exceptional returns given their mandate, consider using ETF’s to keep your fees down, because in this low rate environment, whatever you can save in fees goes straight into your pocket.