Investors have enjoyed a bond market rally for the past few decades but, sadly, all good things must come to an end. Like Yogi Berra said, “the future ain’t what it used to be”.  Having become accustomed to steady bond returns for decades as interest rates trended downwards, investors may be in for a rude shock if interest rate rise.

Here’s what you need to know about bonds today:

Diversification is queen

One of the key reasons to have bonds is the diversification they provide: bond returns are inversely correlated with stock returns. That means if equity markets go down, high-quality bonds almost always go up. Adding high-quality bonds to a stock portfolio lowers the overall risk.

Extreme couponing – how low can they go?

Buying bonds has rarely been as unappealing as it is now. A $1,000, 10-year Government of Canada bond (the top quality bond) carries a coupon rate of 1.8 per cent per year. (Compare this to the same quality of bond 20 years ago that paid 7 per cent.) Today’s bond yields are similar to rates on guaranteed income certificates (GICs). In other words, they are barely keeping pace with inflation before taxes. There are higher-yield bonds in the market, such as corporate bonds, but they carry more risk than bonds backed by the government.

The ‘See-Saw’ effect

Interest rates and bond prices are like a see-saw. When one goes up, the other goes down; when interest rates rise, the prices of bonds will decrease. Here’s why: Let’s say interest rates rise to 3%. The new $1,000, 10-year bond has a 3% coupon. Now, your measly 1.8% bond is less attractive to buyers, so the price drops. (Note that if you hold your bond to maturity you still get your principal back. You would only incur a capital loss if you sold your bond before maturity.)

The name’s Bond Funds

The bonds held inside a mutual fund or exchange traded fund are traded on a regular basis, locking in losses if interest rates rise. The longer the term to maturity, or the duration of the bonds in the fund, the bigger the negative impact of a jump in interest rates. Many investors prefer to hold bond funds rather than individual bonds, since bond funds are easier and cheaper to buy, and they can be held indefinitely. Note that just as the price of the bond fund goes down when interest rates rise, the price would rise if interest rates fall down the road.

What should you do?

The answer depends on whether you’re a passive or active investor. A passive investor trusts her asset allocation and rarely deviates from it. In that case, if the bond portion of her portfolio underperforms, she’ll buy more bonds/bond funds the next time she rebalances to get back to her original asset allocation.

On the other hand, if she has a more active investment style and expect rates to rise, she’d act now and invest in bonds with shorter bond durations or even reduce the proportion of bonds in her portfolio. As a substitute for bonds, she could simply shop around for short-term GICs with favourable rates. Not a bad place to park some of the money while waiting to see where rates go.

Preparing for the shock

Given our historically low interest rates, they’ve got to head higher at some point. If you work with an adviser, a good conversation-starter would be “where should I invest as interest rates rise?”