Long Term Bonds: The Perfect 'Recession Insurance'?
Why should you bother owning long-term bonds?

On the surface of it, they aren't very interesting creatures at all. They don't pay a huge amount of interest - currently only around 4.8% for long-term Government of Ontario bonds. Why bother with 4.8%, when you can get higher yields of around 8% or so from other instruments like income trusts, high yield bonds, or even equities?

The reason why you should bother, and what most people don't know, is that under the right conditions, (usually a steep recession), long-term, low-yielding bonds can absolutely rocket in value. They are one of the very few asset classes that can appreciate dramatically during a recession or depression. In the 90's, when Japan experienced outright deflation, gains in Japanese long-term bonds were 30% in some years.

But how can this be? How can bond prices change so dramatically?

The best way to explain is to use the example of Guaranteed Investment Certificates (GICs). Suppose you purchased a $10,000 GIC in 1980, with a long maturity of 35 years, and an interest rate of 15%. And by the way, back in the 80's, as some of you must remember, interest rates really were that high. Now, fast-forward to 2006. You own the same GIC, and it still pays 15%, and there are still 10 years left on it. A new, 10-yr GIC pays only 4%. So you are a very happy camper indeed to own such a high-yielding GIC.

Now, if someone offered to buy that GIC from you today for $10,000, what would your response be? Undoubtedly, you would tell them to get lost, either politely, or with various colourful embellishments, as is your custom. Why sell a GIC paying 15%, when, new GICs pay only 4%? In order to be willing to sell this GIC you would almost certainly demand that the buyer pay you a much higher price than the $10,000 face value. You would only sell it if the price were so high as to make you indifferent between holding the old and buying a new one. This premium price might be something on the order of $19,000. You would insist on being compensated for the higher rate on your existing GIC. What has happened here? Your GIC rose dramatically in price.

This is exactly how bonds are priced. After you purchase a bond, interest rates may go up, or they may go down. If they go up, a prospective purchaser of your old, lower-rate bond will insist on a lower price, because your bond 'ain't so great' anymore, compared to new, higher paying bonds. Conversely, if rates fall, he will be willing to pay a premium to you for your bond, because it has a higher rate than new bonds.

But why long-term bonds? Why not just buy a 2 or 3-year bond? Well, if your old bond pays higher interest than new bonds, you want to maintain that advantage for as long as possible. The longer the duration of the bond, the longer your 'interest rate advantage'.

These price changes are no small matter - bond returns can be almost as good as stocks, but with a lot less risk. As of January 2006, the 20-year return on Canadian bonds has been 9.45%. This compares to 9.62% for Canadian equities over the same time period. So owning bonds doesn't require a lot of sacrifice in terms of performance. Source: Globefund.ca

In 1992, long-term Japanese government bonds yielded 3.2%. Now, 3.2% doesn't seem too exciting, and as I recall, there was almost no interest in owning Japanese bonds then, because 'everybody knew' that rates couldn't go any lower. But they did go lower - all the way to 1.5%, and this pushed long-term bond prices up over 30%. Furthermore, this was in the face of a Japanese stock market crash, and economic stagnation, which rendered every other investment, including and in particular real estate, a disaster.

Long-term interest rates tend to fall during a recession, after economies slow and central banks cut interest rates. Two years ago, I recommended real return bonds for the purpose of protecting against an unexpected increase in inflation. I wasn't necessarily predicting it, but I did want inflation insurance. Well, long-term bonds can be considered recession, deflation, and housing market collapse insurance. In a nasty recession, the sustainability of incomes from other sources may become questionable, whereas government bonds and high-quality corporate bonds carry little if any risk of default.

Here's a question I get all the time:

"I'm 70 years of age. I probably won't even live for 30 years, so why should I buy a 30-year bond?"

The error in this question is the false assumption that you are locked in to these bonds. Not at all. You can sell at any time. And after all, corporations are expected to exist more or less permanently, not just for 30 years, but we don't avoid shares just because we expect the corporation to outlive us. Same thing here: we buy these bonds because we think they are worthwhile investments right now. If they appreciate sharply, we can sell. There is no law that says our investments must mature on the day we die.

There's another reason why I like this asset class: no one else does! I have rarely seen such a widespread consensus in the market as I do now concerning a lack of interest in long-term bonds. History shows that usually the least-loved investments have a better-than-expected return going forward. Certainly that's what happened to Japanese bonds in the early 90's, and - who knows? - it could happen here too.

I'd be more than happy to further discuss the merits of long-term bonds for your specific financial situation. Quite possibly you don't have any exposure to this asset class now. I have spent over 18 years in financial services, in Canada, Singapore and London. Call me today for a free, no-obligation consultation. It will be well worth your time.

Sincerely,

Scott Swallow, HBA, MBA, CIM