WEALTH Matters — FALL 2013

BOND PRICES DROP IN 2013

Most portfolios contain both bond and stock funds. Stocks provide for growth opportunities to keep up with rising prices, while bonds generally return no more than inflation once tax on interest is taken into account. Bonds provide stability at times when stock markets suffer downturns, so they play a defensive role in portfolio construction, and a place to hold profits taken after a strong stock market performance.

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Interest Rate Trends

Investment Market Commentary

BONDS DROP IN 2013

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Portfolio Allocation

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When bond investors expect inflation to increase, they will demand higher interest rates on new bonds to compensate. This causes the prices of existing bonds to fall so that their effective yield aligns with the market rates on new bonds. This is why we’ve seen a decline in bond prices and bond fund values over the past several months

Longer-term bonds are more sensitive to changes in interest rates. The DEX Universe index graphed above has an average duration of just over 6 years, similar to many well-diversified bond portfolios. You can see its value declined about 6% from May to September when the 10-year bond yield rose about 1%. At the time of writing, the price of such a portfolio would still be down almost 4% from a year earlier, but reinvested interest would have recovered some of the loss.

The drop in value is somewhat superficial – it only applies if you need to sell. If the portfolio manager continues to hold the bonds until they mature, then they will still mature at the same date and value expected before the price drop, and will still pay the same amount of interest as before the price drop, so the future cash flow is unchanged. Any new money invested in the existing portfolio would buy the bonds at their new lower price and experience the higher effective yield.

Richmond Hill’s Top Choice for Financial Advisors in 2011, 2012 and 2013.

Portfolio managers can use several strategies to minimize possible price declines in case market interest rates on government bonds continue to increase:

· shorter-term bond portfolios are less sensitive to interest rates than longer-term portfolios.

· corporate or high yield bonds are less sensitive to interest rates than government bonds.

· many foreign government bonds already pay higher rates than north-American ones.

· floating-rate bonds increase their rates with changes in market yields, so their prices are much less sensitive to interest rate changes.

· hedging strategies can be used in a bond fund to offset bond price declines if interest rates rise.

Some or all of these strategies are already being employed in bond funds which we oversee for our clients. Despite recent weakness in total bond returns, and the possibility of future interest rate increases, bonds remain an important part of your portfolio’s defensive component. Please give us a call if you would like to discuss defensive strategies for your portfolio.

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