Like so many other young hockey players who idolized Bobby Orr, I was elated when my first hockey coach assigned me to play defence. My hero was and still is considered one of the greatest defencemen the game has ever seen. Having received personal skating lessons from my father (an accomplished figure skater) for two years before ever playing a formal hockey game, I had a relatively strong stride, and loved to pick up the puck behind my net at full speed to see if I could pull off a Bobby-like end-to-end rush.
On one occasion I swept in behind my net at full gate to pick up a loose puck and begin my rush when the blade of my stick got jammed in to a crack in the boards. The stick clamped at full-stop, and my momentum took me straight in to its butt-end. The stopped stick speared me in the chest, sending a sharp pain in my sternum and knocking the wind out of me.
What should have been a routine defender's sweep behind the net resulted in me being shish-kabobbed on a Koho and hung out to dry. If I am grateful for one thing, it is that the accident impacted a young, flexible fifteen year-old body, and not the aging, flabby fifty year-old bones I drag around the ice now.
When a defenceman picks up the puck near centre ice, he might hear a shout from his team-mates: "Last man back!" This means, whatever move he makes needs to be sure. Any error could, and likely will, result in a clear breakaway for the opposing team.
What if the tried and true defender suddenly became a defensive liability? If you own mutual funds, be mindful of a defender who is now becoming risky business.
With rates at all-time lows, and potentially moving upward over the next few years, the once-safe bond portfolio inside your mutual fund might soon cough up the puck, and the safe part of your portfolio may become more of a hazard.
Here's how it works:
Let's say you have a piece of paper in your hand that says a credit-worthy man named Joe promises to pay you:
1) the $100,000 you loaned him at the end of 10 years, and
2) 4% per year (or $4,000) until the ten years is up.
Call this piece of paper in your hand "Bond A."
The plot thickens: Joe is still credit worthy, and is still borrowing money from other investors.
The next day interest rates go up one per cent.
Bond B: Now meet Fred. Fred was thinking about buying Bond A from you. However, now he can spend $100,000 and earn $5,000 per year instead of the $4,000 your contract is locked in at.
What is Fred to do? More importantly, what are you to do if you suddenly need your $100,000 back before the ten years is up? The answer is, you sell Bond A for a little less than you paid for it to entice Fred to buy it from you instead of Bond B from Joe directly.
This is a simplified example, but the point is, when interest rates go up, the value of the bonds in your portfolio go down.
Currently, interest rates are hovering near historic lows, and most economists concur that they will eventually rise. If that is true, then outstanding bonds, particularly those with a low interest rate which are locked in for long periods may experience significant price drops as interest rates rise along the way.
In 1981 the prime lending rate was around 19 per cent. Those days are long behind us, thank goodness. Since then, we have seen a 30 year decline in interest rates, and bonds have been our old reliable, defensive friend.
Funny thing about math: if you turn it upside down, the opposite thing happens. Looking ahead, we might see the hockey stick turn the other way, and interest rates angle upwards. The extent to which this happens will reflect on our bond portfolios, inside or outside of mutual funds.
Bonds will still remain an important part of downside protection for some portfolios through the rebound in rates. But keeping contracts short (duration low) and being mindful of the innovative skills of fund managers is now more important than ever. And if that risk is not for you, then straight forward guaranteed investment certificates (GIC's) might be your new defensive friend.
Mark Ryan is an advisor with RBC Wealth Management, Dominion Securities (member CIPF) and can be reached at [email protected].
