Prudent investment management theory directs investors to a mix of safe/lower return and more risky/higher return investments. Typically, the safe/lower return component includes “debt instruments”, meaning GICs, bonds, strip bonds, CSBs, TBills, etc and mutual funds which invest in these.

Investors define safety in terms of predictability and guarantee of cash flows — both interest and principal repayment. However many of these “safe” investments do not always meet these criteria. Periodically, rising interest rates result in declining values and loss of capital, if you panic and bail out. This results from the inverse relationship between the value of bonds and the prevailing market interest rates: when market yields increase, the value of bonds decreases. (see “Prices and Yields“).

The accompanying table shows the gain or loss in capital value on a 10% coupon bond when market yields are changing. You will see that the gain/loss is more significant the longer the remaining term of the bond. You will also see that the percentage gain/loss is not symmetrical. For instance, a 1% rise on a 5 year bond is -3.77% vs +3.96% for a 1% fall. The overall return on a bond is the cash return reflected in the periodic interest payments plus any gain/loss. As you can see, the gain/loss on bonds can have a significant impact on the overall return.

 1 year  5 years  10 years  15 years  20 years
+5% -4.49% -7.16%  -25.49%  -29.53%  -31.49%
+4% -3.62% -14.05% -21.19% -24.82% -26.66%
+3% -2.73% -10.78% -16.53% -19.59% -21.22%
+2% -1.83% -7.36% -11.47% -13.76% -15.05%
+1% -0.92% -3.77% -5.98% -7.27% -8.02%
0% N/A N/A N/A N/A N/A
-1% .94% 3.96% 6.50% 8.14% 9.20%
-2% 1.89% 8.11% 13.59% 17.29% 19.79%
-3% 2.85% 12.47% 21.32% 27.59% 32.03%
-4% 3.83% 17.06% 29.75% 39.20% 46.23%
-5% 4.82% 21.88% 38.97% 52.33% 62.76%

The strategic investor is faced with a few choices here. First, shy away from debt instruments which carry risk of capital and stick with GICs, etc. Second, remain steadfast through a bad bond year like 1994. Ride it out, accepting your yield to maturity as determined when you bought the bond and plan to hold it until the end. Third, the aggressive investor may place bets on the direction of interest rates and plan for topping up the cash return with gains.

While the first approach is the least risky, the cost is lower returns, as these instruments typically yield less and may not have liquidity. If you can remain calm through short-term storms, your yields will be higher with the second approach than the first. Your need for liquidity also bears on this decision. If you may need to cash out your investment for personal use, the timing of that may expose you to risk of gain/loss. However, if your money is in for the long term (e.g. within an RRSP), you can ignore this constraint. With the third approach, after you have happily taken a gain on selling the bond pre-maturity, you must then address the reinvestment decision: You gave up the yield to maturity, so now what are you going to do?

If you achieve your debt component through mutual funds (bond, mortgage, income funds), you should assess your exposure to gain/loss by understanding how the fund manager is investing. The risk profile of the fund is determined by the investment strategy. Is there exposure to currency risk from investing in foreign (or foreign-denominated) bonds? Is there credit risk from investing in low credit-rating borrowers (“junk bonds”)? How much risk is there to movement in market rates? Remember the accompanying table: The longer the term to maturity, the more the risk of gain/loss. The “average term to maturity” of the fund’s portfolio is a published statistic.

In conclusion, an understanding of what bond investments can do for your portfolio will help you achieve your objectives. Nasty surprises can be eliminated from risks that you didn’t know you were taking: consciously chosen risk is far preferable.