Clark Wealth Management Group - ScotiaMcLeod Fredericton

As happens when there is a planned fire drill, and we are not alarmed by the sound of the sirens, investors today could be missing what may be real warning signs of trouble in bond markets.

In the midst of their collective terror of the possibility of losing more money in the stock market, Canadian and Global investors have been rushing into the perceived safety of bonds – often through bond mutual funds. The Investment Funds Institute of Canada’s (IFIC) statistics for October 2010 show that this trend is not changing. In October 138% of mutual long-term asset fund in-flows went to balanced and fixed income funds. Global and Domestic equity funds are still in net redemption.

Investor’s comfort with bonds is well founded, even if potentially misplaced. Since the early 1980s bond investors have faired quite well as interest rates moved lower. The result of this secular downtrend in rates has arguably given investors the wrong impression – that you can’t loose money investing in bond funds. While it’s true that over the past 30 years losses have been limited, that was then and this is now.

Crazy things are happening in bond markets. While the examples cited are in the US, it also applies to Canada. Recently Norfolk Southern (primarily a US rail operator) was able to issue a 100 year bond paying 5.95%. Who even knows for sure that railways will be around in 100 years, let alone Norfolk Southern? Consider the fact that General Motors had a AA credit rating 30 years ago. They’re now about to rise from the ashes of bankruptcy made possible only by the US & Canadian governments taking over ownership of their business. Here’s another crazy one; IBM recently issued a 3 year bond paying 1 percent. What, one percent for three years? Who would buy that?

According Merrill Lynch, “the average yield on investment grade bonds with maturity exceeding 15 years is at the lowest level since the bond index began in 1986.” What this really means is that bond prices have never been higher in the past 24 years – yet investors continue to pour money into bonds at an incredible pace with the view that at least they won’t lose any money.

Warren Buffet rarely paints himself into a corner when answering questions. When interviewed recently on CNBC and asked if he thought the US bond market was in a bubble he said, “I think short-term and long-term bonds are a very poor investment at the present time.” This guy is no slouch when it comes to investing. Perhaps he’s onto something.

While fixed income securities have a place in almost every portfolio, now is a time to tread carefully in bond markets. In the current environment GICs can be a reasonable alternative to individual bonds since they are invariably held to maturity and are guaranteed by the issuer (and CDIC to certain levels) to mature at their purchase price. If you must use bonds, consider limiting yourself to high quality issues and bond funds with a short average term to maturity. There are some good exchange traded fund alternatives to consider here.

Alarm bells are ringing more often recently about the flow of funds into increasingly overheated bond markets. Although you may be tempted to ignore them based on the experience over the past few decades, assuming bonds are guaranteed and you can’t lose money, think again. The bond market is a much larger and an infinitely more complex place than the stock market.

Talk with your advisor about how to get you correctly positioned from an asset allocation and fixed income product perspective – just in case alarm bells ringing about a bond market bubble are signalling a real problem.

Keir Clark, is a senior wealth advisor, with Clark Wealth Management Group and branch manager at ScotiaMcLeod in Fredericton, NB. He can be reached online at www.keirclark.ca or by telephone at 506-450-6465.

Information and opinions contained herein have been compiled from sources believed reliable but no representation or warranty, expressed or implied, is made as to the accuracy or completeness.