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Look at both sides of investment potential
Bonds continue to attract investor interest across the globe. Despite rising stock markets since March, there is enough bad economic news to squash investor enthusiasm for stocks. After three gruelling years of losses, investors are content to sit in the safety of bonds. But are bonds a real safe haven today, or do investors have a false sense of security. Investors would be well served, not only by looking at the return they're getting, but also at the risk to which they are exposed.
Bond valuations
In North America, long-term bond yields are approaching 5.5 percent. With a free cash flow yield of about 4.5 percent for the S&P 500 stock index, bonds currently represent better relative value at the moment. Bond yields continued to decline through June, but July saw a strong up tick in rates across the board from short- to long- term and government to corporate bonds.
It should be noted, however, that although government bonds seem to be better value than stocks at the moment, they have a risk of their own - i.e. interest rate risk.
Bond duration
There is a measure used in academic circles to approximate the interest rate risk of bonds - i.e. duration. Currently, the bond market (as measured by the Scotia McLeod Universe Bond Index) has a duration close to 6 years. Taking into account the time value of money (i.e. that a dollar today is worth more than the same dollar in the future), duration measures the time required to recoup a bond's purchase price.
As a rule of thumb, for every 1-percentage point rise (fall) in bond yields, there is a price decline (appreciation) equal to about the duration - 6 percentage points in this case. Since the relationship between bond prices and yields is not linear (i.e. it's a curve and cannot be illustrated with a straight line), this is just an approximation.
During the month of July, Canadian bond yields rose by an average of about 33 basis points (i.e. 33/100 of one percentage point), which sent the bond index down by about 1.5 percent. That's a large movement for a single month for bonds and shows the vulnerability of bond investors today.
Even with yields up over the past month, buyers of bonds today face a significant risk. If the economy begins to post more consistent, even modest growth, bond investors will have their heads handed to them. I'm not talking about stock market type losses, but rather significant losses that can take investors by surprise.
For instance, the 5.44 percent yield on long-term government of Canada bonds would effectively be wiped out by another 1 percentage point rise in bond yields over the course of the next year. This is a very realistic scenario.
When the economy is really burning rubber, it's common to see rates rise by 2 to 4 percentage points inside of a year. I'm only talking about a rise that is but 1/4 to half of that amount - i.e. what would be expected in a more moderately growing economy. I'm not making a prediction but, rather, stating that it's a very realistic possibility.
Recommendation
It will come as little surprise that my recommendation is to keep your investments, and risk exposures, diversified. Slowly rising rates will be good for stocks because it will likely happen in the midst of a healthy and growing economy. Hence, having assets spread around will ensure your ride stays smoother without betting the farm on one particular outcome.