Oh, I Have Slipped the Surly Bonds of Earth…

In previous columns, we have discussed patience and that the route to success was buying low and selling high, not buying high and selling low. Our discussions have usually revolved around the equity markets. I think it is time that we gave some time to the bond markets.

2011 finished with world equity markets mostly down (the US was essentially flat). Interest rates on GICs and savings accounts remain at abysmal levels and both the US Federal Reserve and the Bank of Canada have indicated they are prepared to leave their official rates at historic lows for the near future and probably for the next couple of years. Government bond yields have been driven incredibly low. The average market yield for bonds over 10 years is no better than the 5 year GIC rate of a sad 2.6%.

At the same time, anyone that has owned Canadian Long Bonds or US Long Treasuries the last few years has experienced stellar capital gains. In fact, almost all classes of bonds around the world have produced outsized gains over the last few years. This has not gone unnoticed and many investors are tempted to distance themselves from an equity market that continues to disappoint and embrace more bonds.

This leads me to repeat some previous cautions about buying low and selling high, not buying high and then selling low; patience; and most importantly, being prudent is not the same as being stupid. Just this time apply them to bonds. The problem is that bonds have an inverse relationship with interest rates. As rates fall, bonds go up in value. That is exactly what they have done for most of the last 30 years and certainly there is no argument that they have gone up a lot more in the last 3 years as governments responded to the financial crisis by cutting interest rates to historic, and previously incomprehensible, low rates. Thus, bonds have reached their most expensive point ever. Without a doubt, the price of bonds is not low. The buy low, sell high proposition is clearly in doubt here. We are also admittedly not sure at all that the bond bull is ending yet. We think it may even go another year. My point is that when interest rates DO turn and begin to rise, the capital gains achieved in bonds will be given right back. If you buy now AND do not sell before the turn you will have a permanent unrecoverable loss of a very large magnitude. We also do think that if you got last year’s gains and think the party will last, stay in but take some of the winnings off the table, since you could get the time of the turn wrong. The ONLY reason to enter the party, and buy bonds today, is that you believe the potential outsize gains this year will warrant taking the risk of staying too long. This is a trading strategy and since we believe that we will only know the bull has stopped after it has stopped, many investors will miss the trade to get out. Therefore, we would rather be out early than late because late will be extremely expensive and wealth destroying.

Where does that leave us? If you are a new buyer and rates stay the same, you get exactly the rate you made your purchase decision on, for the life of the bond. Currently, as a new purchaser of a 10 year Government of Canada bond, you will be committing yourself to a yield for the next 10 years of just over 2%. That is less than the expected forward inflation and about equal to the average inflation over the last 20 years. If inflation is higher going forward than the last 20 years, you will be committed to losing purchasing power for the next 10 years. Not much of a bargain.

If rates go up government bonds and most corporate bonds are going to go down in value. They will then stay in a loss position until interest rates fall again to new historic lows or maturity. How long do you think that will be once the crisis passes? When will your next opportunity to sell high come if you have bought them at the highest prices ever seen? You may well have created a situation of buying high and never having any other opportunity than selling low all the way to maturity. To earn more than the current yield, market yields will have to continue to fall to provide you with a short term capital gain. This is a buy high sell higher strategy. If you buy bonds fresh this year and we do not think you should, you need to be focused on selling all the way up to ensure you have a lower position at turn.

Remember, the markets do not destroy wealth, untimely actions do. Swear to buy only low and never high and keep the commitment. Be patient during periods of rising bond or equity markets. Wealth is built by buying right not jumping in when returns are high.

At Efficient Wealth Management, we build portfolios that do include bonds, GICs and cash KNOWING that they will underperform the stocks in the long term. My clients are ALL told that we are including bonds, GICs and cash to the extent we feel is necessary to keep them in the markets. Having the potential of achieving the highest returns does you no good, if the short term volatility of the stock market causes you to fold your hand. Decreasing the return by using a balanced approach is the cost of ultimate success. So bonds are very important to the strategies for our clients. So how are we dealing with this? We are suggesting prudence, caution and remaining patient until bonds are low and can once again, safely be acquired for their portfolios. 2012 may indeed see both rising equity and bond markets, and this will be good for all invested investors but the highs will be higher and since low is what we are waiting for, buying more will be delayed. We certainly will miss a short trip up but we will slip those surly bonds…

*With thanks to John Gillespie Magee, Jr. “High Flight”