September 13, 2010, 5:00 am

A Few Tips To Protect Yourself Against Bonds Collapse

by: The Financial Blogger    Category: Investment, Market and Risk
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Funny enough, it seems that we cannot escape risk; the market is hyper volatile, and bonds are threatened by interest rate hikes. So how can you protect yourself from bond values dropping?

As you may know, bond values can go down. When?  In exactly the situation we are facing; when interest rates rise, bond values drop. When you think about it, it is quite easy to understand. If interest rates increase, new bond issues need to offer a higher interest rate to match the new reality. Therefore, old bonds with lower interest rates attract a lesser price from investors whom will sell them to buy the higher interest rate bonds. Since everybody would like to sell their low interest paying bonds, the bond values decrease.

So if you have a lot of bonds in your portfolio, here are a few tips to consider to make sure that you are somewhat protected against a bond collapse:

Long term bonds

Long term bonds will be the bonds with the highest risk upon an interest rate change. Why? Because they will offer a lesser interest rate for a very long period. This is why investors will be less likely to give a great value to long term bonds. So if you have them in your portfolio, make sure you don’t need to sell them. Keep your long term bonds to maturity, this is the only solution to keep your yield safe.

Gov Bonds

I would avoid government bonds for the moment. Why? Simply because they don’t pay much! If you are absolutely looking for safe investment, consider provincial or municipal bonds that will offer a better invest return while offering a similar level of security to government bonds.

In fact, the only government bonds I would consider would be the real rate investment bonds that protect the investor against inflation. Since the Canadian interest rate is greatly influenced by inflation, you should maintain an “interesting” yield on those bonds.

Junk Bonds

This is the type of bonds that is less likely to lose the most value if the interest rate rises. Why? Because corporations will have to offer a much higher interest rate to issue more bonds. There is always a spread between government bonds and junk bonds and the spread can increase when there is a panic in the bond market. So if investors think that bond values will drop due to increases in interest rates, they may panic and request a much higher premium for junk bonds.

If you plan on having junk bonds in your portfolio, make sure that you follow the issuer because you may get stuck with it for a while!

Bond Funds

Some say that you should get rid of your bond funds when we expect a drop in the value. I’m not part of them ;-). I would rather ask my financial advisor what is the duration of my bond portfolio and how I am at risk with the bonds held in my funds. Ask about the bond managers strategy as well.

A good bond manager has already decreased the portfolio duration (selling long term bonds to buy more short term bonds) to make sure that the bond fund doesn’t drop drastically.

Mortgage funds could be another great opportunity. They are more likely replicating the same movement of bond funds (because mortgages look like bonds in their structure) but they are less volatile due to their smaller duration. Mortgage funds often hold government bonds and provincial bonds as well.

Dividend and Preferred Shares

Tired of dealing with bonds and their potential collapse? You can always turn towards dividend stocks and preferred shares ;-). While they are riskier than bonds, they offer a somewhat steady payment through dividends which are less taxed. We are writing on The Dividend Guy Blog if you are interested in dividend stock picking.

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It may be the right time to consider acquiring physical gold as a great alternative against inflation.