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Why bond mutual funds are a great way to control risk

Resist the temptation to sell your bond funds because of their low returns. They provide needed 'ballast' in the event of stormy stock markets.

Bond funds provide needed 'ballast' in the event of stormy stock markets.



As tempting as it might be, think twice before dumping high-quality bonds or bond funds because of their lacklustre performance. Though they're not expected to do much for you in terms of returns, bonds still play a crucial role. They'll provide needed “ballast” in the event of a stormy equity market.

So says Paul Bosse, a strategist with Vanguard Group Inc., the U.S.-based fund giant whose Canadian subsidiary manages a family of 21 exchange-traded funds.

Historically, when stocks have been at their worst, investment-grade bonds have not only preserved capital but also produced slightly positive returns. “Quality bonds are a great way to control risk in your portfolio,” Bosse says.

Bosse is a principal with Vanguard's investment-strategy group, which earlier this year produced a forecast of the range of global fixed-income returns over the next 10 years.

Vanguard's forecast is based on various potential scenarios for inflation, interest rates, economic growth and other market variables. The most probable outcome, according to the forecast, is for global fixed-income returns ranging on average between two and 2.5 per cent a year.

Don't count on much more than that, even in a bullish scenario for bonds. According to Vanguard's forecast, the likelihood of global bonds returning more than 3.5 per cent on average over the next 10 years is very low, with a probability of a little more than 10 per cent.

On the plus side in terms of preserving capital, Vanguard's forecast indicates that it's highly unlikely that bonds will return less than 0.5 per cent or lose money over the course of the next 10 years.

In their search for higher yields, income-hungry investors have embraced alternatives such as high-dividend stocks, real estate investment trusts and high-yield bonds. (The latter are riskier credits that are below investment grade.)

The problem is that all of these income-generating alternatives are much more volatile than the mainstream bond markets and will still have negative returns in equity bear markets. Bosse's advice: “Think about using the bonds that do the best job of controlling risk.”

If you accept the argument in favour of continuing to hold high-quality bonds, interest-rate risk is an important consideration. That is, whether to hold some long-dated bonds, such as those with 10 years remaining until their maturity dates, or stick with bonds with shorter maturities.

The longer-dated the bond, the more vulnerable it is to rising interest rates, since bond prices and interest rates move in opposite directions.

However, Bosse and his colleagues expect that when interest rates move up, most of the movement will take place in the short and intermediate maturities, rather than at the long end of the yield curve.

Under this scenario, yields of long-term bonds would remain fairly stable. As a result, interest-rate shocks might not be as severe for these bonds as for some shorter maturities.

Yet another argument in favour of high-quality bonds is that their expected low returns should be viewed in context. Sure, they might return only two to three per cent on average for the foreseeable future.

But stock-market returns may also be well below their historical norms. Stocks might return only six to eight per cent a year, Bosse suggests, down from the average return of more than 10 per cent since the early 1970s.

This suggests you can expect returns in the range of five per cent for balanced portfolios, assuming a sizeable allocation to bonds. At that rate, it would take nearly 15 years to double your money, and that's before inflation and taxes. It all adds up to a market environment in which a balanced approach will enable you to get rich slowly -- very slowly. Twitter: @rudyluukko