Volume 91, Issue 66
Tuesday, January 27, 1998
Investing in long-term opinions
As uncertainty blooms in the equity markets, smart investors look for safer alternatives to hedge against the inherent risk of equities in their portfolios.
Most economists agree that the stock markets are heading into a period of little growth relative to performance during the past three years. Some predict that we are heading into a bear market, where the value of stocks depreciate. In such an environment, one must look for low risk investments which still have the potential of satisfactory returns. Government of Canada long-term bonds can offer those qualities.
The basic principle governing the bond market is the relationship between the price of bonds and interest rates. These two variables are inversely related. If interest rates fall, the price of bonds rise. If the market rate is lower than the interest rate the bond pays annually, a premium will be incorporated into the price of the bond.
While short-term rates hover at 4.25 per cent, 30-year long-term bonds yield approximately six per cent. Recently, the rate of inflation dipped below zero, which set the stage for an unprecedented difference between nominal interest and inflation rates, or the real rate of return. The reaction to a high real return was a rally in the bond market, where yields have dropped and bond prices increased.
Most economists predict long-term rates to fall between 5.25 and 5.5 per cent during the next year. Yesterday, a Government of Canada 30-year long-term bond yielded 6.01, with an interest rate of 6.5 per cent and price of $106.87. If rates fall by 0.5 to 5.5 per cent, a capital gain of approximately five per cent will realized. Thus, the investment would yield a total of 11 per cent over one year.
This investment strategy speculates which direction interest rates will move. However, if interest rates increase, a bond will have a capital loss.
One factor which may lead to a rise in interest rates is the state of the dollar, which reached its lowest point since 1858 on Wednesday. A weak dollar causes the price of imported goods to rise, which can lead to a higher rate of inflation, which in turn, exerts upward pressure on rates. Also, in order to support the value of the Canadian dollar by attracting foreign investment, the Bank of Canada may be tempted to raise the bank rate.
Investing in long-term bonds is not risk-free. But unlike equities, bonds pay guaranteed interest that can counter-balance capital losses due to rising interest rates.
A balanced portfolio can contain a small percentage of long-term bonds, but the combination of over-exposure and rising rates can lead to significant losses.
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