The Pitfalls of Bond Investing: Interest-Rate Risk

May 14, 2012

Bonds are generally considered a “relatively safe” asset class, and rightfully so. But they are not risk-free. One of their key pitfalls, which should be taken into account by bond investors, is interest-rate risk.

Bond returns have been boosted by a decline in yields in 23 of the 31 years since 1981 (see Figure 1). When yields decline, they propel bond prices upward, thereby adding capital gains to the interest income on the securities. The longer the bond maturity, the larger are the gains. For example, in 2011, the DEX Long-Term Bond Index produced an eye-popping 18% return—three-quarters of which came from capital gains.

Figure 1: Long Government of Canada Bond Yields 1981–2012

Source: Bank of Canada, PWL Capital

Will this decline in bond yields continue? No one can say. Several analysts have pointed out that, since long-term Government of Canada bonds yield roughly 2.5%, there is probably more room upward than down. But how much room? Figure 2 below shows that the decades preceding the 1980s were pretty much a mirror image of those that came after.

Figure 2: Long Government of Canada Bond Yields 1949–1981

Source: Bank of Canada, PWL Capital

Going forward, rising yields would create capital losses, especially for a portfolio that holds very long-dated bonds. Please find below the projected one-year return on a 5-, 10- and 30-year Government of Canada bond in the event of a 1% yield increase.

Table 1: Projected Bond Returns, Assuming a 1% Yield Increase Over One Year

Source: Bloomberg

In conclusion, the sustained decline in yield over the last 30 years has added a great deal of capital gains to bond interest income. This may leave investors with the impression that bonds are not risky. But in a rising interest-rate environment, long-dated bonds can experience severe negative returns. While rock-bottom interest rates may tempt some to extend maturities in order to get a little more yield, PWL believes that the extra income provided by bonds maturing beyond 10 years is not worth the risk.

Raymond Kerzérho

Chairman of the Investment Committee
and Director of Research
PWL Capital Inc.