It is commonly understood that bonds contribute to the “safety” of a portfolio. In asset allocation strategy, some percentage of the overall portfolio typically is dedicated to bonds, aka fixed income. It is perceived that the higher the proportion allocated to bonds, the safer, more conservative the portfolio because the rest of the portfolio may be invested in, and exposed to, the stock market.

We tend to take the safe, “bedrock” aspect of bonds for granted. In the investing world, “safe” is always a relative term. Bonds are considered safe because a) the investor receives periodic contractual cash flow (called interest) and b) a contractual return of principal at some stipulated time in the future. The predictability of these cash receipts allows the return on the investment (“yield”) to be known at the outset. Most of the time, this is exactly how it works. That simple arrangement can go awry if the borrower fails to meet its half of the contract by not making the payments as promised. In the extreme case, a borrower may default due to its declining financial condition, resulting in the cessation of interest payments and possibly the failure to return the capital. An investor can minimize the chance of this unfortunate event by selecting who is lent money, and thus we have bond rating services which attempt to assess the financial health of borrowers. Large borrowers in the marketplace include all levels of government. Generally, governments are ascribed a very low probability of default, due to their ability to tax their constituents if they get into financial jams. So, in conclusion here, bond risk can be mitigated by carefully selecting to whom you lend money.

But bond risk doesn’t end here. Another level of risk can result from currency. In selecting borrowers, an investor may choose to lend to borrowers from other countries. Generally speaking, these borrowers borrow in their own domestic currency. Sometimes they borrow in a “gold standard” currency, most typically today the US dollar. Either way, for Canadians this means adding a currency aspect to the lending equation. If the Canadian dollar moves appreciably up (down) during the holding period of the foreign bond, then the cash flows will decrease (increase) in Canadian spending power over the duration of the bond contract. Of course the biggest cash flow, and ergo the biggest currency risk, is the big repayment of the principal at the end.

As the loonie has strengthened against the US dollar over the past few years, converting a matured US bond back into Canadian dollars has had a large currency loss component, causing the overall return to be negative… in fact as big as –10%!

A third aspect of bond risk is the movement of interest rates. When an investor is seeking to invest in a bond at a particular point in time, the yield on that bond reflects market interest rates at that time. During the life of that bond, world and domestic economics can cause future interest rates to move up or down, which has a bearing on the yield paid for new bonds purchased at that time. But it also has an impact on all of the bonds previously issued and still outstanding. On any given day, every bond extant is priced in the market place, based upon current interest yield. For most investors, this is irrelevant because they don’t plan to sell their bond to somebody else on any given day – they will hold it to maturity and have it redeemed by the borrower. BUT, when an investor receives the monthly brokerage statement, all of these bonds are nonetheless priced by today’s yield environment.

The article entitled Capital gains and bond portfolios at discusses this valuation issue in greater detail. In the example cited there, a 1% increase in current bond yields drops the current annual return of a 5 year bond with a 10% coupon by a full 3.77%. A 2% increase would drop the current return by 7.36%. Furthermore, the longer the term to maturity of the bond, the bigger is the fluctuation, eg that 1% increase causes a 5.98% drop in current return for a 10 year bond. Lastly, this impact is even larger for strip bonds, as opposed to semi-annual coupon bonds, because all of the cash coming back is deferred to the maturity date.

This issue is what we are seeing now as we progress through our 2006 round of annual reports to our investors. Interest rates have been rising over the past year: the prime rate increased from 4.25% in June 2005 to 6.00% in June 2006.

So for example, a portfolio of bonds with an average term to maturity of four years had a current annual return to March 31st of 3.76%, yet its term-to-maturity yield is 5.48%; thus, the movement of interest rates over that year shaved 1.72% off the return for the short term of one year. More recently, another bond portfolio with an average term-to-maturity of three years had a current annual return of only 1.92% to July 31st, yet its term-to-maturity yield is 4.09%, a drop of 2.17%.

Remember: if you hold a quality bond portfolio to maturity, you get the yield as calculated upon purchase… 4.09% in the above example. Only a paper, or unrealized, lower return occurs when we enter a rising interest rate environment.