Existing bondholders will suffer implied portfolio losses or explicit losses if they sell their bonds. For now, the downside created by the rate hike is slight, as the market is betting that the BoC will not hike the overnight rate set in March 2020 until the second half of 2022.
The question for advisers is how much potential gain to sacrifice when the cost of portfolio insurance for holding low-yielding bonds must rise.
Investors happy with pure equity risk may not see the need for bonds, but for clients who may need cash, the case for bonds is stronger.
“For a client who uses a portfolio to generate income, bonds offer a way to get money without having to sell stocks when they are down,” said Caroline Nalbantoglu, head of CNal Financial Planning Inc. . to Montreal. “Customers benefit from convenience and liquidity. There are other instruments that generate income – for example, REITS and utility stocks – but they are stocks and go in the direction of most stocks in bear markets. “
Advisors have other ways to contain volatility. Put options can set a limit on the downside, but the investor has to pay for this protection. Covered income calls can cover the cost of the put options, but complexity comes with its own risks. Non-financial assets may not be covariant with stocks, but an investment such as farmland is illiquid and does not easily sell in pieces, Nalbantoglu said. Additionally, the more esoteric an asset, the wider the buying and selling spreads tend to be and the harder it is to get reliable price discovery.
A client’s timeline is a critical metric for portfolio allocation. If the outlook is weeks or months, stock volatility is significant. For a perspective of 5 to 20 years, big corrections are to be expected. In this context, bonds reduce the total return of the portfolio, but they provide a sense of comfort as well as income, thus reducing the need to sell stocks in a bear market, said Chris Kresic, Head of Fixed Income. and asset allocation at Jarislowsky Fraser Ltd. in Toronto. .
“Equities have a nominal annual return of 4% forecast based on current valuations, and bonds have a nominal annual return of 2% going forward,” he said. “A cost of 2% to stabilize a portfolio and provide liquidity is really not that high. “
So moving from a 60/40 to 90/10 allocation would create a long-term yield gain of 1%, Kresic explained. That’s not much considering the psychological incentive to get rid of losers in a falling market.
The period of very low bond yields could be coming to an end. Rising interest rates mean that the cost of holding bonds will rise, but so may equity returns.