Dale Jackson

Personal Finance Columnist, Payback Time

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Retail investors who like the security of fixed income in their portfolios might be encouraged by the recent news that the yield on the U.S. 10-year government bond topped three per cent. It’s a sign higher yields are coming – but it’s the first of many traps being laid for savers.

Before I explain, it’s important to understand the difference between institutional bond traders and retail bond traders. Institutional bond traders seek gains by trading on the basic principal that as bond yields rise, bond prices fall. They make money on the price differences. A 10-year bond with a set rate, for example, is traded many time before it matures based on price differences caused by fluctuating interest rates. 

Retail bond traders, on the other hand, use bonds as fixed income to temper risk from the volatile equity portion of their portfolios. That means they buy and hold bonds until they mature – often staggering maturities over several time periods to present more opportunities to get the best going yields. It’s called a “laddering” strategy.     

Bond yields have been paltry since central banks slashed interest rates a decade ago in the wake of the global financial meltdown, which explains why three per cent might look good. But there’s a reason bond prices go down as yields go up. As interest rates and yields rise, that same 10-year U.S. bond will still yield three per cent in five years, making it less lucrative compared with new bond offerings.

Right now, rates at the long end of what is called the “yield curve” are just about equal to rates at the short end, making the yield curve flat.

Most bond traders and financial advisors warn savers not to take the bait and continue to keep their maturities short until rising rates at the long end outstrip rates at the short end, and the yield curve steepens.