Put bonds into your retirement plan

Are bonds really safe? asked the headline in a recent edition of The Globe and Mail Report on Business. The lengthy article was accompanied by a cartoon showing a couple in a car marked “Bonds” driving towards the edge of a precipice, concealed behind a mirage of sunny skies.

The message seemed clear – buying bonds now is a recipe for disaster for your retirement portfolio. Actually, the story was more balanced than that, but if you only read the first half-dozen paragraphs you’d probably have been ready to sell all your bonds the next day.

Bonds are important
That would be a big mistake. Bonds have been one of the few salvations for shell-shocked investors in recent months. And no matter what happens going forward, bonds should form an important part of any well-balanced RRSP or RRIF portfolio.

The article made the point that bond prices fall when interest rates rise, and referred to the carnage in the bond markets in 1994 when the U.S. Federal Reserve Board aggressively raised rates to ward off the perceived threat of inflation.

The implication was that it could happen again.

Sure it could. But right now, no e is talking about raising interest rates.

Interest rate impact
On the contrary, there’s growing speculation that the U.S. could start cutting interest rates again, if not now than in the fall.

We’re also starting to hear warnings of an economic slowdown in Canada. Should that happen, the Bank of Canada may have to rethink the rate hikes it has already implemented this year.

In short, we could be in for a prolonged period of continued low interest rates, which would be good news for bond investors. The odds of that happening certainly look better right now than the possibility of big rate hikes in the next year.

Next page: Think long term

Think long term
But whatever happens short-term, bond investors should adopt a long-term outlook. The history of the Scotia Capital Markets Universe Bond Index is very revealing in this regard.

Over the decade to July 31, the index generated average annual returns of 8.37 per cent.

Over 20 years, the average annual figure was 11.87 per cent.

Of course, interest rates were much higher during much of that period. But the three-year average annual return, which is more reflective of the current situation, comes in at a healthy 7.25 per cent.

The point is that, over time, bonds are healthy contributors to any retirement portfolio and they add a badly-needed element of stability during periods of stock market turmoil.

A balanced RRSP portfolio should have a 40 per cent income component (bonds and other income-generating securities).

A RRIF portfolio should be weighted even more heavily to the income side.

Focus on maturity
If you’re still worried about the short-term prospects for bonds, then focus on those with maturities of five years or less. They aren’t as vulnerable to interest rate movements, up or down.

An easy way to invest in this type of security is to buy the iG5 units that trade on the Toronto Stock Exchange under the symbol XGV. They represent units in a fund that has one asset, a five-year Government of Canada bond.

The fund makes distributions twice a year, and the one-year return to July 31 was a very attractive 9.3 per cent.

Of course, falling interest rates contributed significantly to that result, and you shouldn’t expect that kind of return over the next 12 months. But this is a low-risk way to add bonds to your portfolio at a time when uncertainty abounds.

If rates drop further, your iG5s will do very well. If they rise, you won’t be badly hurt.

Stick them in your RRSP or RRIF for the long haul and then move on to other problems.