A reader wrote to me recently asking why he should own any bonds in his portfolio.

After all, he noted, interest rates are going up and we all know that means bond prices will fall. So logically he should dump them and invest everything in stocks.

I can understand his thinking. While the Bank of Canada is holding the line on rates, the U.S. Federal Reserve Board is pushing them higher. While it didn’t take action this week, the Fed did raise its target rate by a quarter-point in December and has signaled there will likely be three more increases this year. That’s pushing up commercial rates (e.g. mortgages) across the continent.

Bond prices are already reflecting that. As of the close of trading on Jan. 27, the FTSE Russell Canadian Universe Bond Index was off 0.35 per cent for the year. Government bonds fared especially badly, down 0.54 per cent year to date.

That pattern is showing up in the returns on bond mutual funds and ETFs. For the six months to Dec. 31, the average fund in the Canadian fixed income category was showing a loss of 1.9 per cent.

Those may not seem like large numbers but they indicate a trend that is likely to continue through the year unless something dramatic happens to change the interest rate dynamic.

So back to the question: Why own bonds if they’re going to lose value?

Let’s start with safety.

That may seem like a strange thing to say when prices are falling, but the downside risk of owning bonds is far less than stuffing your portfolio with equities.

When the stock market tanks, it doesn’t fool around. Between October 2007 and March 2009, the Dow Jones Industrial Average lost almost 55 per cent of its value.

According to a column by Nobel laureate Robert J. Shiller in The Guardian, the biggest one-year drop in the total return index for U.S. 30-year corporate bonds was 12.5 per cent in the 12 months ending in February 1980.

In fact, when stock prices plunge, bonds tend to rise, providing a cushion for your portfolio. Anyone who was invested fully in bonds when the market crashed in 2008 actually ended up making money.

The second reason is stability.

Remember that while the market price of a bond will fluctuate, if you hold it to maturity you’ll receive the full face value (assuming the issuer remains solvent). In the meantime, you’ll collect predictable periodic interest payments — an important advantage to anyone seeking regular income.

Finally, remember that no one can accurately predict the future.

Last year at this time, everyone was expecting the bond market to tank. In fact, bonds moved sharply higher in the summer when interest rates fell. They gave back a lot of those gains after the Trump election win but still ended 2016 in the black.

If you do decide to own some bonds, you need to decide how much you’ll invest. That depends on the extent you want to insulate your portfolio from the potential effect of a stock market crash.

A study published in The Boglehead’s Guide to Investing, which is available on Amazon, showed that a portfolio that was 100 per cent invested in equities during the crash of 2000-2002 lost 37 per cent of its value. One that was invested 100 per cent in bonds gained 33 per cent. A portfolio that was 40 per cent bonds and 60 per cent stocks just about broke even.

If you are still nervous about bond investing at this stage, here are three tips to reduce your risk.

Buy 90-day Treasury bills: They don’t pay much — the yield on the latest auction was 0.46 per cent. But unless the Government of Canada goes bust, your money is absolutely safe.

Invest in short-term bond funds: These invest in securities with maturities of five years or less, making them less risky. They can still lose money in a falling bond market, but if that happens, the decline is minimal.

Buy some high-yield bonds: Bonds are not all created equal. High-yield bonds (sometimes called junk bonds) have done well in recent months despite the overall decline in the market. In 2016, the average high-yield bond fund posted a gain of 10.25 per cent. However, let me stress that these bonds can be very volatile so conservative investors should use caution.

If you are still not convinced you want to own bonds right now, your alternative is to hold cash. You won’t make any money, but you won’t lose any, either.

Gordon Pape is editor and publisher of the Internet Wealth Builder and Income Investor newsletters.

Gordon Pape is editor and publisher of the Internet Wealth Builder and Income Investor newsletters.

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