Bonds: How many are too many?

Striking the right balance between bonds and stocks provides both capital gains and steady income

By Andrew Allentuck
Globe Investor Magazine online, December 4, 2008

Bonds are a great way to shield a portfolio from the heat of the stock market meltdown. But buy too many of them, and you risk missing out on the brisk returns that stocks can provide.

So how do you find the right balance between fixed income and equities, risk and certainty, capital gains and steady income?

The rule of thumb is to hold bonds in a portfolio at a ratio equal to your age, says Adrian Mastracci, a portfolio manager and financial planner who heads KCM Wealth Management Inc. in Vancouver. So, at age 45, your portfolio is 45 per cent bonds, while at age 70, it's 70 per cent bonds, he says.

"The rule reflects the diminishing amount of time investors have to make up for major stock market losses," he says.

For example, a 70-year-old investor in the market with a $100,000 portfolio should have $70,000 in bonds and $30,000 in stocks. Canadian equities have lost about 31 per cent in the year to Oct. 31, while bonds have gained about 3 per cent on average. So, in this example, the investor would have lost $9,300 on equities and gained $2,100 on bonds, with the fixed-income component absorbing about a quarter of the losses on equities.

But the rule "is too crude," Mr. Mastracci says. "It lacks sensitivity to the risks that are already in the investor's portfolio. What you have to do is to examine the person's risk tolerance and then set up a bond-to-stock ratio."

Matching stock and bond volatility is the key to having them balance each other. For example, Asia-Pacific equity funds fell 40 per cent in the year to Oct. 31, while global bond mutual funds rose 12.1 per cent.

"To adjust portfolio bond weight, look at the historical performance of your stocks," Mr. Mastracci suggests. "If you have very volatile stocks or mutual funds, raise the bond ratio."

For example, if you are heavy on Canadian small-cap to mid-cap funds, which were down 40.3 per cent, or emerging markets, down about 47.2 per cent, you could safely add a third to half to your age-based bond allocation, Mr. Mastracci says. Small-caps and emerging markets are always more volatile than large-caps and major markets, he notes.

Which bonds you hold matters a great deal. The bonds that work best to balance stock moves are those that respond directly to changes in central bank interest-rate changes. The least effective bonds are corporate bonds, including junk bonds, whose prices and prospects for default are linked to the business cycle.

Indeed, the two kinds of bonds move in opposite directions in tough times, for government bonds are seen as sure bets with little risk while all corporate bonds are seen as having potential credit issues. Junk bond funds, for example, lost 14 per cent in the 12 months ended October 31, while the Citigroup World Government Bond Index rose 31 per cent. The reason -- government bonds issued in their own currencies have almost no default risk because their issuers can print money.

Investors can cushion stock volatility by going with a broad bond mutual fund or by buying shares of the iShares XBB exchange-traded fund. It has a management fee of 30 basis points and can be traded just like a stock through any fully licensed investment dealer.

Claymore's 1-5 year Laddered Government Bond ETF, which trades on the Toronto Stock Exchange as CLF, has a management fee of just 15 basis points. The Claymore fund, with its selection of short bonds, has even less risk than the broad market XBB ETF because it is not as sensitive to interest-rate changes.

Special to The Globe and Mail