Why Bonds May Still Be Good For You

The Current & Future Environment For Fixed Income Markets & Investors:

Most new investment dollars put into mutual funds last year went to bonds. Most bonds across the board (provincials, corporates, high-yields, short-term, long-term, real return) rallied to a significant degree during 2009 due to a lowering rate environment, a contraction in credit spreads and lower than anticipated bond defaults. The outlook for long-dated  federal, provincial and high-quality corporate bonds will be poor if we experience rising interest rates   The Bank of Canada overnight lending rate has been drawn down to 0.25% - most analysts are expecting the rate to be upwardly adjusted in small increments during the years to come beginning Q3 of this year.  With interest rates due to rise, what should an investor do?

Short-Term bonds and bond funds that were widely sold as money market alternatives may be a liability since while their durations are short, the quality of the issues is extremely high and thus more liable to rate increases.

How Can We Make Money in the Bond Market this Year and Years to Come?

Interest rates will be adjusted upward when overall economic conditions improve and GDP growth is also on the rise.  At 0.25 percent, there really is nowhere to go but up, once the economic recovery gains traction.  As we experience better overall economic conditions and improved GDP growth, defaults within high-yield bonds will decline. In relation lower credit quality investment-grade bonds, improved GDP growth and better overall economic conditions will mean credit qualities improve.
This means that the potentially negative effect of rising interest rates may well be off-set by the positive effect lower default rates have on high-yield bonds and the progression in credit quality, lower quality investment-grade corporate bonds experience, spurred by improved economic conditions.

Yet another consideration is that under these circumstances: It is anticipated that many high-yield bonds will become investment-grade (going from BB to BBB ratings) and become eligible for purchase by a variety of institutional purchasers (Pensions, Endowment Funds, Corporations etc...) increasing demand volume.

In other words, corporate and high yield bonds may be the ideal fixed income alternative in an improving economic environment.