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Have bonds become too risky for RRSPs? We like some risk in our investment portfolios, of course…up to a point! A little risk carries with it the potential for more reward. But too much risk can give us a bad case of sleepless nights. Recently some investment gurus have been saying that if interest rates start to climb, bonds could suffer from “interest rate risk.” That could come as a bit of a shock if you’d always thought bonds were a pretty “safe” sort of investment – especially for something as important as your retirement nest-egg. Let’s clear up some confusion about this.

It’s true that the highest-quality bonds, usually rated “AAA” by rating agencies, are safe. But this means they are “safe” in terms of the potential for default. In other words, the issuer of the bond is highly unlikely to renege on interest payments to bondholders. In the case of top-rated government, or “sovereign,” bonds, such as those issued by the Government of Canada or the U.S. Treasury, the possibility of default is remote indeed.

Where the risk is 
Where the risk comes into play is in the pricing of bonds. Once issued, bonds are traded in an informal (albeit very large) market. And because of the inverse relationship of bond’s price to interest rates, a bond’s price will fall if general interest rates rise. Conversely, bond prices rise when rates fall. (It’s a complicated mathematical relationship that essentially keeps a bond’s yield competitive in the marketplace.)

Those high-quality government bonds will always pay the stated coupon rate, which is based on the face, or par, value of the bond. What you actually receive is the “yield” of the bond based on the price you pay. So if you paid the face value (usually stated as “$100”) on a bond that carries a 2% coupon rate, your yield will be 2%, or $2 per $100 of face value. But if you paid something other than face value, your “yield” will be either higher or lower than the coupon rate.

When analysts talk about “interest rate risk,” they’re not referring to whether or not the bond will pay its interest. They’re referring to the bond’s price. If interest rates rise, the price of your bond may fall below your purchase price, resulting in a capital loss if you sell your bond before maturity.

How fund managers cope 
In actively managed bond portfolios, such as those you’ll find in fixed-income mutual funds, managers will adjust their holdings in an effort to mitigate interest rate risk. They do this in various ways, including tilting bond holdings to longer or shorter maturities; or investing in bonds with different risk ratings, in different regions or countries; or attempting to anticipate interest rate moves – all depending on the mandate of the fund as set out in its prospectus. Some funds can be quite successful at this – the recent Fundata FundGrade A+ Rating 2012 Awards contained a fair number of bond funds.

Exchange-traded bond funds (ETFs) are also available, and their MERs are generally lower than for fixed-income mutual funds. Bond ETFs usually aren’t actively managed, and they are available in many configurations, including those that track short- and long-term indexes, as well as indexes of government bonds, corporate bonds, all bonds, laddered maturities, and so on. It can get complicated.

Bonds and your RRSP 
So no, bonds have not become “too risky” to include in RRSPs. They are no more or less “risky” than they’ve always been. In fact, most advisors agree that a well-diversified portfolio should include some weighting to fixed-income assets. In general, investing in fixed-income assets can be just as complex as investing in equities, sometimes even more so. As always, it all comes down to where, when, what, and how much you allocate to bonds.

If you’re confused about how bonds work and the best type of fixed-income investment to include in your RRSP (and as you’ve seen, it’s very easy to get into a muddle about bonds), consult a qualified financial advisor. But do it soon. The final day for making your 2012 RRSP contribution is March 1.