Interest rates are likely to remain low for several months at least, which is good news for bonds.

I received an e-mail inquiry from a reader recently who was concerned about putting any new money into bond funds. He wrote as follows:

“Since interest rates in Canada and the U.S. are at all-time lows, it stands to reason that they can only go up from here (especially if inflation rises and central banks increase rates to curb inflation).

“Therefore, this means that bonds (and bond mutual funds) will do poorly since interest rates and bond prices are inversely related. Question: Is my reasoning correct and is this indeed now a bad time to get into a bond mutual fund?”

My immediate reaction was to reply that it is rarely a “bad time” to invest in a bond fund (or in bonds), providing you do so for the right reasons and are in for the long haul. But given that interest rates are very low, a more detailed explanation is in order.

For starters, remember that nothing is certain in this world. While it is generally assumed that interest rates will rise in the future (although probably not for at least the better part of a year), that’s not a given. Keep in mind that U.S. Federal Reserve Board Chairman Alan Greenspan continues to warn that the risk of deflation is about on a par with the risk of inflation right now. A deflationary scenario would mean that interest rates could indeed go lower than they are today, especially longer-term rates.

There is also the issue of the strong loonie, which is being driven higher by the wide spread between U.S. and Canadian short-term rates. If the trend continues, the Bank of Canada may decide to ease interest rates in this country, and we have more leeway to cut from current levels than the U.S. does. The low level of inflation we’re now experiencing would make such a decision easier and last week Bank of Canada Governor David Dodge signaled that he is open to the possibility of further rate cuts.

In short, we could remain in a low interest rate environment for several years, which would make bond funds quite attractive.

The greatest threat to the net asset value (NAV) of bond funds is a sudden, sharp rise in interest rates. That looks very unlikely to occur any time soon. A more gradual rise can be handled by a good money manager. Bond fund managers are extremely sensitive to the interest rate environment and adjust their portfolios accordingly.

A rise in interest rates will not affect the cash flow from a bond fund, because the securities in the portfolio will continue to pay their coupon rate. It is the NAV that will bear the brunt, which means that if you sell in such conditions you could incur a capital loss.

If you wish to minimize your risk, you can do so by focusing on short-term bond funds and mortgage funds. These will be least vulnerable in a rising interest rate environment. The trade-off is that your returns will probably be lower than from a conventional bond fund.