Not all bonds are equal for soothing the beast.
To achieve the best investing results in the real world, we need to avoid the bad investor behaviors driven by our emotions. One approach to that while building our portfolio is to use some bonds.
The effectiveness of bonds for soothing our inner emotional investor beast depends on how well they dampen volatility. That lies in how strongly they are correlated with other holdings in our portfolio (usually equities). A low or preferably negative correlation is desirable. It also depends on how wildly the bond price fluctuates (less is better).
Different bond types can perform differently in these regards. That is largely determined by the risks that underly them and the factors that affect those.
While generally lower risk than equities, all bonds do carry some degree of risk.
Some bond types are more subject to different factors (like the economy or government fiscal health) than others. How much these factors overlap with those affecting equities can influence their correlation and relative volatility compared with equities. Hence, different types of bonds may have variable efficacy for dampening volatility to prevent emotionally driven mistakes from smashing our real-life investing performance.
We’ll examine the following risks, how they impact bond correlation to stocks, bond price volatility, and approaches to mitigate them:
- Credit Risk
- Term or Maturity Risks: Interest Rate Risk & Inflation Risk
- Currency Risk
- Liquidity Risk
- Specific Risk
There is the “credit risk” of loan default.
This risk is higher with high yield or “junk bonds”. High yield bonds are issued by companies that are riskier. Therefore, they need to offer higher interest rates to entice investors. Government bonds are generally the lowest risk because of the governmental powers of taxation. Still, that governmental stability and power can also vary between countries – or even within countries at different levels of government.
Buying higher quality bonds helps mitigate credit risk, but they have lower yields to account for that. The credit risk of a bond can also change over time if the fortunes of the issuer change dramatically. The longer the duration of a bond, the more exposure to changing conditions there is.
There is also the “term risk” or “maturity risk” of conditions changing before the bond matures.
These changes affect the capital value of a bond at any given point in time before maturity if you want to sell it on the secondary bond market. The more time remaining before the bond maturity date, the more the effects on price are magnified. The interest payments remaining before maturity plus some other factors determine the duration of the bond.
The bond duration describes the remaining sensitivity to changes in the prevailing conditions. It is actually based on the remaining interest payments pending before maturity. The duration acts like a shifting fulcrum for a catapult as shown below.
So, longer maturity bonds carry more term risk. This is why they generally have higher yields when issued to entice investors to commit.
The biggest term risk to bond value in nominal dollars is “interest rate risk”.
This is the risk that the prevailing market interest rates rise while your money is locked-in at a lower rate. When the yield of newly issued bonds goes up, the price of existing bonds drops because they no longer look as attractive. How big that price drop is, depends on how long the money is tied up in the bond before it matures. As a term risk with the fulcrum-catapult effect of duration illustrated above: small interest rate changes will cause big price changes in longer-term bonds. This makes long-term bond prices more volatile.
Using shorter-duration bonds or a bond ladder (holding bonds of different maturity dates) helps to mitigate term interest rate risk.
“Inflation risk” doesn’t change the bond price in nominal dollars, but can affect your purchasing power or “real return”.
For example, if you have a bond paying 3%/yr and inflation rises at 4%/yr, then that bond would have a real return of -1%/yr. Conversely, a drop in inflation increases the purchasing power of your returns. Inflation risk cuts both ways.
The bond yield at the time of issue usually exceeds projected inflation. Otherwise, why invest? However, inflation over long periods of time is less predictable. Therefore, this risk of unexpectedly high or low inflation rises with longer bond maturities.
Treasury Inflation Protected Securities (TIPS) are US government bonds with payments indexed to inflation. Unfortunately, TIPS have currency risk for Canadian investors, which we will examine later in this post. Fortunately, if you want to use inflation-protected bonds, they are also issued by the Canadian Federal and provincial governments. The Canadian version of TIPS are called real return bonds (RRBs).
Real Return Bonds Hedge Against Upward Inflation Risk
Real return bonds are not sold at discount brokerages. However, there are RRB tracking ETFs, called XRB.TO and ZRR.TO, that are.
The details of how RRBs are priced and work is complex. Basically, the bond is issued with a % real interest yield that stays constant while the payment in non-inflation-adjusted (nominal) dollars rises at the rate of inflation. The market value of an RRB consists of the principal value (at a discount to face value) plus an Inflation Compensation (IC) adjustment. The Inflation Compensation is increased twice per year according to the consumer price index. However, the IC is not actually paid out until the bond matures. I have tried to simplify this to a picture below.
The practical effect of this is that the interest payments (taxed at your high marginal rate) rise each year pegged to inflation. The other effect is that the value of the bond also rises each year. Even though you don’t receive the money from the IC until the bond matures, you pay tax on it annually as income (full rate). Hence, if you use RRBs, put them in a tax-sheltered account like an RRSP or TFSA to side-step this double tax-whammy.
Overall, RRBs are a bet on future inflation.
If inflation turns out lower than anticipated, they underperform conventional bonds. They outperform if inflation unexpectedly takes off. A mix of conventional bonds and RRBs could cancel that inflation risk out. However, the average maturity-date for these bonds is long (20 years) giving an average remaining duration of about 16 years in the Canadian Real Return Bonds ETFs. So, term risk is a real concern. Further, fluctuations in both the prevailing interest rates and the inflation rate (which tend to go in the same direction) can cause increased volatility. As you can see in the chart below, volatility of RRBs is about double that of conventional Canadian government bonds.
With the credit and term risks in mind, let’s look at the correlation and volatility of some different bonds types in more detail.
The data in the above table illustrates some key points:
- Bonds from large powerful governments, such as US Treasuries, were inversely correlated to equities in this time period. That is ideal for smoothing volatility when mixed with equities.
- Bonds issued by companies had some correlation to equities. The correlation is low (good) for stable companies, like those held in LQD at 0.22. In contrast, the riskier company bonds in HYG had a high correlation coefficient of 0.72 to equities. This makes sense because the default risk that these companies pose fluctuates with how well the economy is doing and how vulnerable they are to a downturn. Similar to equities.
- The volatility of HYG is also higher because of that sensitivity to economic conditions.
- Comparing the volatility of TLT, IEF, and SHY shows the effect of term risk nicely. The longer-term maturity TLT fund was about twice as volatile as the moderate maturity term IEF fund. The short-term fund had negligible price changes.
I have used US bonds and equities for my analyses in the above table because that is where the easiest to use long-running datasets are. However, for Canadian investors specifically, $USD:$CAD currency risk usually increases bond price volatility as described below.
For Canadian investors, foreign bonds also introduce “currency risk”.
There is currency risk from fluctuations of the $CAD relative to the $USD. We live in $CAD and no one can reliably predict the $USD:$CAD at any future point in time where we may want/need to access our invested money.
For the most part, yields on Canadian and US Government move together. Our economies are closely linked, so this makes sense. However, the currency volatility between the $CAD and $USD could easily exceed the bond yield.
Plus, as shown in the chart below, the $CAD is positively correlated to the US Treasury Yield. Since price moves in the opposite direction from yield, that means that when the $CAD rises, it is associated with a drop in US Treasuries prices. US Treasuries priced in decreasingly valued $USD. So, that drop is accentuated even further. To make that confusing relationship more clear visually, green in the chart below is a good and red is bad (makes the bond price more volatile).
This makes US Treasuries much more volatile when converted to $CAD. That can defeat the volatility dampening purpose of holding US Treasuries in a portfolio.
You can purchase CAD-hedged US Bond ETFs that mitigate that currency risk.
However, the pickings are pretty slim. VBU.TO tracks the US Aggregate Bond Market hedged to CAD and contains 63% Treasuries with the rest of the bonds being investment grade. There is also HTH.TO which is a swap-based TRI ETF of 7-10yr US Treasuries hedged to CAD. However, HTH.TO comes with a different set of tax benefits and specific risks from using the special swap-based structure.
The effect of currency on the volatility, measured by standard deviation, is shown in the table below. The time frame of the data set is much shorter than looking at Bond ETFs from US exchanges. However, it still illustrates the point.
As you can see above, the volatility of unhedged bonds is double to triple that of the CAD-hedged version. For bonds to optimally play their role of soothing volatility in our portfolio, we would want the lower volatility and negative correlation to equity of the CAD-hedged versions. If we use US bonds.
Liquidity Risk & Specific Risk
Liquidity risk is the risk that you may have a hard time buying or selling a bond because everyone else is trying to do the same thing. Basically too many people rushing for the door and they can’t all fit. You may be forced to sell for less or pay more to get through. It could happen because of a large herd movement or because the door is small. The small door in this analogy would be for thinly traded bonds or bond funds.
The table below shows the average trading volume for some common Canadian bond ETFs. This is not a perfect measure for liquidity risk. On days with events that trigger major portfolio changes, the trading volume can spike. However, you can infer that if you are buying or selling $40K of HTH.TO in a single day to rebalance, that you may have difficulty.
This may not be an issue if you can spread your trade order out over several days. That is often not a problem for the long-term investor who is simply rebalancing or adding to a position.
The world bond market is huge and the liquidity of government bonds is generally excellent. In contrast, many corporate bonds are more thinly traded. That problem worsens when dealing with smaller companies. Even with large companies or governments, they could run into trouble and trigger a herd stampede. That is their specific risk.
Using a bond ETF instead of individual bonds can help diversify against specific risk.
An ETF mitigates specific risk by holding hundreds or thousands of different bonds across a broad market. They are also easy to buy/sell with minimal commission via a discount brokerage.
However, ETFs can still run into liquidity or specific risk.
This is particularly true for smaller specialty bond funds. They have a smaller volume of buyers/sellers that can result in liquidity risk.
There is also the specific risk in that the ETF operating company may have problems or decide to close the fund due to a lack of interested investors. The fall-out of that would be being forced to realize capital gains or losses whether it is an opportune time or not.
Optimizing The Use of Bonds In Your Portfolio
There will always be a trade-off between investment return and risk. If there were not a risk premium, then investors would not be enticed to take a chance. Although there are some periods where bonds have outperformed over the long-term, they are rare. Equities are most likely to offer the best long-term returns given the increased risk.
Our goal with bonds is not to simply get the best yield.
We are better off with equities for that.
The role of bonds is to counter-balance the risk and volatility of our equities enough that we can ride the ups and downs of the market roller coaster without jumping off the roller coaster at a bad time.
The two components to soothing the beast with bonds are:
- Choose bonds that are the most negatively correlated to equities and the least volatile.
- Choose enough of an allocation of bonds: equities that you can stomach the overall portfolio volatility without provoking your emotional investor beast.
Today we looked at which bonds best fulfill aspect #1.
The factors that affect bond risk also determine their correlation to equities and volatility. Balancing all of those risks together, bond ETFs from fiscally strong governments seem to do the job best. ETFs are helpful to reduce risk by diversifying amongst many bonds and are convenient to buy/sell.
There is a balance between lower volatility from shorter-duration bonds and their lower yield. Inflation is also a threat, but it can cut both ways and hedging for it increases volatility. Not what we want with our volatility-dampening goal for bonds. There are other ways to hedge for inflation.
For Canadian investors, there is currency risk that makes Canadian bonds most attractive. There are a few CAD-hedged US bond options, but they invoke liquidity and specific risks.