Tuesday, October 20, 2009

The Future of Bonds

Rob Carrick wrote a provocative piece about the effect of rising interest rates on the bond market called Latest horror flick: Attack of the bond market. This made me take a look at how bad the carnage would be if interest rates rose.

Poking around at my online brokerage, I found a $100,000 Canadian strip bond coming due 2029 Dec. 1 that they would sell to me for $43,818. When you own a strip bond you don’t get any periodic payments; you pay for it, and in this case you get your $100,000 when it comes due, unless you sell it first.

The return on this bond works out to 4.19% per year for just over 20 years. However, according to the Bank of Canada, the average return on long-term Canadian bonds over the last 10 years is 6.38%. This raises the question, what happens to my strip bond if interest rates return to the average level?

Suppose that in just over 5 years, the yield on my bond rises to 6.38%. By this time, it would be a 15-year strip bond and would sell for $39,546. This price is calculated so that the 6.38% return would make the bond worth $100,000 over the 15 years from 2014 to 2029.

So, my bond’s value would drop from $43,818 to $39,546, a loss of 9.75% in just over 5 years. This is roughly a 2% loss per year before considering inflation. If I owned long-term bonds in a bond mutual fund, the loss would be more like 3% to 3.5% per year because of the added fees.

These potential losses if interest rates return to average levels aren’t devastating, but investors usually choose bonds for safety, not to lose a few percent every year.

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