How bonds help cut your risk

It’s been a rocky year for Canadian stocks in 2015. As of the close of trading on Nov. 16, 2015, the S&P/TSX Composite Index was down 9 per cent for the year, due in large part to a plunge of more than 17 per cent in the energy sector.

It would take a huge, sustained rally to get us into the black by year-end. Don’t hold your breath.

By contrast, bonds are on the winning side of the ledger with the FTSE TMX Universe Bond Index ahead 1.87 per cent year to date. That may not look very exciting at first glance, but it is almost 11 percentage points better than the stock market. That’s a significant spread. Government bonds have done especially well, gaining 2.24 per cent for the year.

Related: A nasty November and slow growth ahead

Bonds (or bond funds) provide an important element of stability for investors, especially in times of stock market volatility, such as we are experiencing now. The higher the proportion of bonds in your portfolio, the lower your downside risk when stock markets tank.

Using the year to date numbers from the TSX and the Universe Bond Index, a portfolio with an allocation of 75 per cent stocks and 25 per cent bonds would be down 6.3 per cent so far in 2015. If the allocation were 50-50, the loss would be 3.6 per cent. At 75 per cent bonds, 25 per cent stocks, the portfolio would be down only 0.8 per cent.

Clearly, the more risk-averse you are, the higher your bond weighting should be.

You can buy individual bonds through full-service brokers, although their inventory will be limited.

You can cross check the price you are quoted at candeal.com, which publishes bid-ask information on a wide range of government and corporate issues. If your dealer’s quote seems out of line, see if you can negotiate.

If you prefer to invest through funds, the cheapest option is bond ETFs.

The iShares Canadian Universe Bond Index ETF (TSX: XBB) has a management expense ratio of 0.33 per cent.

The BMO Aggregate Bond Index ETF (TSX: ZAG) is even cheaper at 0.23 per cent but, surprisingly, its returns are less than the iShares competitor (4.2 per cent vs. 5.8 per cent for the year to Oct. 31).

The Vanguard Canadian Aggregate Bond Index ETF (TSX: VAB) is the cheapest of all with an MER of 0.14 per cent but it also has a lower return than the iShares entry.

As these numbers show, the lowest price doesn’t necessarily translate into the best return.

The bottom line is that everyone should hold some bonds or bond funds. The weighting is up to you but keep in mind that the higher the bond percentage, the lower the overall downside risk.