Is it time for bondholders to rethink their strategy?

At this time last year, two key issues were front and centre for us.  We were concerned about more fallout from the economic uncertainty in Europe and the U.S.  There did not seem to be any clear plan in place to resolve the debt and deficit issues. We were also concerned that interest rates would finally hit bottom and start to climb.  Both issues caused us to be cautious with our clients’ capital in 2012.

The threat of rising rates has been hanging over the heads of all investors for some time now.  Quite surprisingly, rates did not rise in 2012. In fact, they fell – about 0.60% in Canada. Why? Because more stimulus like the Federal Reserve’s bond buying programs was needed to re-ignite the economy.

In anticipation of rising rates last year, we accelerated our plan to diversify our sources of yield for our clients.  We added more income-producing real estate, residential and commercial mortgages, corporate bonds and dividend-paying stocks.  With rates falling, these investments performed well in 2012.

As we look ahead into 2013, we do have some evidence of more economic stability.  The European issues are being better managed. The U.S. outlook is positive and improving.  And once again, we are anticipating higher rates in 2013.  We weren’t wrong last year – just early!

We expect interest rates to increase 1-2% over the next 24 months.  The impact for investors is that bond prices fall when interest rates rise and long-term bonds (i.e. 20-year) are the most affected. These bondholders may see the value of their holdings fall 5% to 15%. We fear that many investors are unaware that this unwelcome outcome is a real possibility.

In our portfolios we’ve been anticipating this for some time and we’ve taken significant steps to protect capital by shortening the duration (i.e. holding shorter term bonds) and reducing our exposure overall to this asset class.

Given the low expected return going forward for bonds, we expect stocks to outperform. Stock market returns may not match the returns we remember from the 1990s.  It will not be a new bull market.  Intrinsically, companies are worth what they earn and the earnings outlook in this very sluggish economy is not robust.

Therefore, we are now conditioning our clients to the realities of holding more stocks in their portfolios once again.  Firstly, we expect lower returns from stocks (i.e., 6%). More importantly, we are reminding them to lengthen their time horizon and to remember that the goal is to earn a reasonable return over the long term.  There are always unwelcome bumps with equities, but we are confident that the end result will meet expectations.

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