Why Government Bonds Are Starting to Look Worth a Second Look

I see a lot of investors, especially younger ones just getting started, going all in on a 100% equity portfolio. They own stocks across different countries and all 11 sectors and assume that means they are fully diversified. In a sense, they are, but only within one asset class.

True diversification goes beyond that. There is real value in holding assets that behave differently from stocks. When equities fall, other assets may hold up better.

That gives you the ability to rebalance, buying stocks when they are down and trimming what has held up. Over time, that process can improve returns and reduce risk. Diversification is often called the only free lunch in investing for a reason.

The question then becomes what to pair with stocks. Some investors turn to gold or even Bitcoin. Those have their place, but there is also a strong case for going back to basics and looking at bonds again, with a bit more selectivity.

In particular, government bonds issued by the Canadian federal and provincial governments are starting to look worth a second look.

Why government bonds?

Bonds serve a few important roles in a portfolio. They provide a steady stream of income, tend to be less volatile than stocks, and often hold up better during equity market downturns. That makes them useful as a stabilizer.

That said, not all bonds are the same. Broadly speaking, you can split the market into government bonds and corporate bonds.

Corporate bonds are essentially loans to companies. Because companies can run into financial trouble, these bonds carry credit risk. Most are rated investment grade, typically ranging from BBB to A, with a smaller number reaching AA or AAA. As you move down the credit spectrum, yields increase, but so does the risk that the issuer may not be able to meet its obligations.

Government bonds are different. Bonds issued by the Canadian federal and provincial governments are generally rated very highly, often AA or AAA. That makes them far less likely to default. You do give up some yield compared to corporate bonds, but you gain stability.

If the goal is to have something in your portfolio that can help cushion the blow during a market downturn, government bonds have historically done a better job of that than their corporate counterparts.

How to invest in government bonds

For most investors, especially those just starting out, buying individual bonds is not practical. Pricing is not always transparent, and you need to understand concepts like yield to maturity, duration, and how interest rate changes affect prices. It is easy to get it wrong.

A much simpler approach is to use somehting like the iShares Core Canadian Government Bond Index ETF (TSX: XGB). It tracks the FTSE Canada All Government Bond Index and provides exposure to a broad basket of government bonds.

The fund holds about 557 bonds, with roughly 57% in federal government bonds and about 40% in provincial bonds. From a credit perspective, the portfolio is high quality. Around 59% is rated AAA and about 36% is rated AA, which keeps default risk very low.

On the income side, the ETF currently offers a 3.1% trailing 12-month yield after fees. The management expense ratio is just 0.13%, which is reasonable for this type of exposure.

In terms of how to use it, it can act as a stabilizer in a portfolio that is otherwise heavily weighted toward stocks. If you are currently 100% in equities, you might consider shifting to something like 90% stocks and 10% government bonds.

There are also simple rules of thumb. One common guideline is to subtract your age from 100 to determine your stock allocation, with the remainder in bonds. So if you are 50 years old, that would suggest a 50/50 split between stocks and bonds.

The post Why Government Bonds Are Starting to Look Worth a Second Look appeared first on The Motley Fool Canada.

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Fool contributor Tony Dong has no position in any of the stocks mentioned. The Motley Fool has no position in any of the stocks mentioned. The Motley Fool has a disclosure policy.