Impact of deflation on bonds

Question: I would like to know about the impact of deflation on short, long term, and real return bond funds. I am looking for a relatively safe place to park my money from the sale of my home as GICs are not very attractive. – M.P.

Answer:

Bonds are usually the most rewarding place to put your money in a deflationary environment, especially government bonds. That’s because central banks fight deflation by lowering interest rates, which generally works to the benefit of bonds. Long-term bonds will fare best in such conditions. Real return bonds won’t do as well because they are pegged to inflation.

One of the main reasons that bond prices have jumped recently is because of continued concerns being expressed by the U.S. Federal Reserve Board about the risk of deflation, along the lines of what happened in Japan. However, most economists think that it is an unlikely scenario since the Fed is going to do everything in its power to prevent it. So don’t take it for granted that deflation in North America is a given.

Placing a big bet on long-term bonds at this stage therefore could involve some significant risk. If the economy sho signs of recovery later this year, bond prices are likely to fall and you could be looking at a capital loss. Short-term bonds offer less return, but also a much-reduced risk level. – G.P.

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