This is shaping up to be a lousy year for bonds but investors shouldn't panic says this fixed-income expert. Buy quality and stay for the long haul.

This is shaping up to be a bleak year for bonds. Looming inflation, higher interest rates, and a soaring U.S. deficit all spell lower prices. So a lot of pundits are suggesting that it’s time to reduce fixed-income weightings or at least shorten term in order to cushion the impact. I disagree. Of course bond prices are likely to drift downward. However, it’s just not a good idea for small investors to play the fixed-rate markets. We almost invariably get hurt.

Now I realize that sitting tight may seem unimaginative to readers who track fixed-income investments. Bonds rally and slump just like stocks, with prices and interest rates moving inversely. So, on the face of it, there are opportunities to make capital gains and enhance the overall return. However, I feel strongly that this is one time when discretion is the better part of valour. Small investors should buy good-quality bonds and plan on holding them to maturity. Here’s why:

First and foremost, the bond market is an unregulated jungle. Second, contrary to general opinion amongst economists, it’s impossible to accurately forecast interest rates. Moreover, despite all the theories, rates, and therefore prices, rarely move in unison. For instance, last year the central banks kept racking up their overnight and Treasury bill rates and driving down prices in the short end but mid- and long-term issues moved in the opposite direction. China and the oil-producing countries spent their cash surpluses buying North American bonds, initially supporting prices and then propelling them higher. At the same time, both ends of the market fluctuated as T-bills and corporate, government, and strip bonds reacted to new issues and re-financings.

To give you an example, in January Canadian corporations issued $7.2 billion worth of debt, up from $3.6 billion during December and $3.1 billion in the same period a year earlier. That saturated the market, causing long corporate rates to buck their slightly downward trend and spike briefly. Any small investor would probably have been caught in the cross-fire. As you can see, we are dealing with an array of moving targets. It’s all a far cry from the broad rate trends linked to business cycles that text books describe.

There is also the problem of transparency. To all intents and purposes, small investors are uninformed about the bond markets. There is almost no media coverage. I have never seen a talking head on TV describing the day’s bond prices in detail. Brokers and dealers provide little on-going retail fixed-income advice and rarely encourage clients to trade. Most important, there is no true auction market for bonds. Issues are traded over the counter from principal positions. That means your broker is selling you a bond from his own inventory and to some extent setting the price. It’s true a few services provide quotes for regularly-traded issues but these are not readily available.

Meanwhile, professional bond traders, who do nothing else, are constantly sweeping the market with sophisticated equipment. They even gauge the spreads between industries noting, for instance, even slight changes in yield differentials between pipeline and merchandising bonds, information unavailable to small investors.

Finally, you have to own an enormous portfolio in order to make meaningful money trading bonds. Price changes are miniscule. The Government of Canada 8% issue due June 2023 rose 6% in price during 2005. The Canada 5.75% bonds maturing 2029 did slightly better during the same period. These were significant movements warranting headlines in one financial journal. Yet to achieve even that modest profit you would have had to commit to the very long end, 20 or 25 years, where price changes are greatest. That’s a risky proposition if inflation takes off. You also had to be a contrarian because experts expected long bonds to decline last year. It’s a poor return for rolling the dice and rewards are even less when you shorten term. A 15 or 25 basis point (1/100 of a percentage point) jump in the five-year Canada is enough to excite the bond traders.

So there you have it. As small investors we face a bond market with limited transparency and slim trading profits where professionals, trading head to head with you, hold all the cards. Even money managers leave bond trading to the experts. We should do the same.