Government bonds for safety

With interest rates so low, Canadian and U.S. government bonds have lost their lustre among yield-hungry investors. But these bonds should still have a place in your portfolio.

“Even though government bonds don’t look too appealing from a yield perspective, they do tend to provide a lot of protection,” says Alfred Lee, an ETF portfolio manager at BMO Global Asset Management in Toronto.

This is especially true when there’s a “flight to quality.” That’s when the market as a whole is concerned that a major downturn is on the horizon and investors are looking for safer assets. “When you have a flight to quality, U.S. and Canadian government bonds do really well,” says Lee.

But not all government bonds have this safe-haven characteristic. European and emerging market bonds have higher yields, but at the price of greater risk. Lee summarizes the key options in fixed income: if you want to stay in North America, think government bonds for safety; corporates and preferred shares for yield. To diversify your higher-yielding options, look to European and emerging market government bonds.

There is nowhere in the world where you can get 4% to 6% tax-advantaged yields on investment grade companies except in Canadian preferred shares.

—Phil Mesman, portfolio manager, fixed income, at Picton Mahoney Asset Management

To access European and emerging market bonds, you’ll need to buy a mutual fund or an ETF, as purchasing these bonds individually is a highly complex process suitable only for large institutional investors. (And even they often use funds.)

Lee adds that, in the current environment, you should expect Canadian and U.S. government bonds to behave differently than European and emerging market bonds if equity markets run into trouble. Specifically, if there were a sell-off in the equity market, European and emerging market bonds would tend to drop along with equities, since “a lot of the concerns the market has right now are coming from [Europe and emerging markets].”

Canadian government bonds and U.S. Treasurys, by contrast, would be more likely to remain steady despite the equity market’s troubles.

Lee says U.S. high yield, European government and emerging market sovereign bonds should get no more than a combined 5% to 20% allocation in your overall portfolio. Each should get no more than a 10% allocation.

And, to reduce interest rate sensitivity, Lee suggests sticking to bonds with less than 10 years’ duration for your Canadian and U.S. government allocation.

Staff

The staff of Advisor.ca have been covering news for financial advisors since 1998.