In the current environment, short-term bonds are your best bet

by Rob Carrick

What to do with bonds right now? Just the opposite of what the federal government is doing.

That’s the sensible recommendation made recently by Raymond Kerzerho, director of research at PWL Capital. Reading the latest copy of the Finance Department’s Debt Management Strategy publication, Kerzerho noted that the feds are extending the maturity of country’s debts. In practical terms, that means issuing more and more 10- and 30-year bonds to lock in today’s low interest rates.

You, the investor, should do the opposite, he argues. While the government’s job is to minimize the amount of interest it pays, investors want to maximize the interest they receive. The best strategy for doing that: Stick to short-dated bonds, which Kerzerho defines as maturing in less than 10 years.

v On the surface, there’s a logical disconnect here. Shorter term bonds have lower yields than longer-term bonds, which is to say you get less interest. The 30-year Government of Canada bond yield in late February was 3 per cent, compared to 1 per cent for a two-year bond and 1.7 per cent for a five-year bond. Why go short, then? To benefit from having bonds that mature in the not-too-distant future and hand you back money you can reinvest to take advantage of any increases in interest rates.

There’s another advantage to shorter term bonds. If interest rates do start to rise, short bonds will fall less in price than long-term bonds. The federal government won’t care a bit if the 30-year bonds it issues today fall in price in the years ahead. But investors may well be stunned at how much long-term bonds will drop in price if interest rates lunge higher.

The bottom line here is that short-term bonds will pay you less in the near term, but you get more stability in a rising rate environment and an opportunity to lock in those higher rates in a few years. Now, what’s the best way to put short-term bonds in your portfolio? A ladder of one- through five-year guaranteed investment certificates works well if you have zero need for liquidity. Individual bonds, government or corporate, can work, but individual investors often get a raw pricing deal on these.

One more idea: A laddered corporate or government bond exchange-traded fund, which you can find in the First Trust, iShares, PowerShares and RBC families. The benefit of the ladder is simple -- every year, you have bonds maturing that can be reinvested at higher rates. If those higher rates ever come, that is.