With bond yields low and rising, what is the price of safety?

The conventional ratio for balancing equity risk with bonds assumed a 60/40 or 70/30 allocation. But with Government of Canada 10-year bonds and U.S. 10-year Treasuries yielding around 1.4% on Thursday — and both likely to rise with the ongoing recovery — the traditional allocations are costly. Fixed-income investors not only have to give up a lot of potential equity upside but must also shoulder the cost of falling bond prices, and be paid a pittance for doing it.

The pressure on both stocks and bonds will increase as interest rates rise throughout the economic recovery from the Covid-19 pandemic. James Orlando, senior economist with TD Economics in Toronto, forecasts the 10-year Government of Canada bond rate will be 2.1% in five years as the Bank of Canada increases the policy rate and stops purchasing government bonds.

Existing bond holders will have implicit portfolio losses, or explicit losses if they sell their bonds. For now, the downside created by rising rates is slight, for the market is betting that the BoC will not raise the overnight rate set in March 2020 until the second half of 2022.

The question for advisors is how much potential gain to sacrifice as the cost of portfolio insurance for holding low-yield bonds is due to rise.

Investors content with pure equity risk may see no need for bonds, but for clients who may need liquidity, the case for bonds is stronger.

“For a client using a portfolio for income, bonds provide a way to get cash without the need to sell stocks when they are down,” said Caroline Nalbantoglu, head of CNal Financial Planning Inc. in Montreal. “Clients get comfort and liquidity. There are other instruments that provide income — for example, REITS and utility stocks — but they are equities and go the way of most stocks in bear markets.”

Advisors have other ways to contain volatility. Puts can set a boundary on a decline, but the investor has to pay for that protection. Covered calls for income can cover the cost of puts, but complexity has its own risks. Non-financial assets may not be co-variant with stocks, but an investment such as farm land is illiquid and not readily sold in pieces, Nalbantoglu said. Moreover, the more esoteric an asset, the wider the buy-sell spreads tend to be and the harder it is to achieve dependable price discovery.

A client’s time frame is a critical measure for portfolio allocation. If the outlook is weeks or months, stock volatility is important. For an outlook of five to 20 years, big corrections are to be expected. Bonds in this context reduce total portfolio return, but they provide a sense of comfort as well as income, reducing the need to sell equities in a bear market, said Chris Kresic, head of fixed income and asset allocation at Jarislowsky Fraser Ltd. in Toronto.

“Stocks have a 4% annual nominal forward-looking return based on current valuations, and bonds an annual nominal return of 2% going forward,” he said. “A 2% cost for stabilizing a portfolio and providing liquidity is not really that much.”

A shift from a 60/40 allocation to 90/10 would therefore create a long-term gain of return of 1%, Kresic explained. That is not much considering the psychological incentive to shed losers in a down market.

The period of very low bond yields may be ending. Rising interest rates mean the cost of holding bonds will rise, but the same may be true for equity returns.