By Scott Ronalds
We’ve been advising clients that safety is expensive these days. In other words, investors are getting paid very little for holding low-risk assets such as money market products and government bonds. The counterpoint is that the latter securities (government bonds) have provided stable income and attractive capital growth over the last several quarters, while the equity markets have been in a tailspin.
Yet, some would argue that the price of safety has become dangerously high. Warren Buffett has even suggested that there’s a bubble in U.S. Treasury bonds. The term bubble may be misleading if viewed as an event that can lead to a permanent loss of capital. You’re going to get your money back from the government, after all, if you hold these bonds to maturity. But portfolios heavy in ‘governments’ could be vulnerable to a price correction.
Consider the facts. The yield on a 5-year Government of Canada bond is roughly 2.0%, while a 10-year bond is at 3.1%. Both are near historic lows. While they may not increase overnight, interest rates will likely rise over the medium-term once the economy gets back on track and inflation starts to re-emerge.
Our back-of-the-envelope calculations tell us that an increase in rates of 1% would lead to a decrease of roughly 4-5% in the market value of the 5-year bond, and 8-9% in the value of the 10-year bond. If rates were to increase by 2%, the 5-year issue would fall 9-10%, while the 10-year bond would drop about 15% in value.
If you buy government bonds with the intention of holding them to maturity, these numbers don’t mean much, as you’ll receive your original investment back at maturity and collect the coupon payments along the way. But those coupon payments are minimal and if you need to sell your bonds prior to maturity, you could be hit with a loss.
There’s also the opportunity cost to consider. High-quality corporate bonds currently offer a significant yield advantage over governments, and have greater upside potential for price appreciation. The point is that with interest rates as low as they are, safety is indeed expensive.