Bond Investing

Bond Investing

 

Why invest in bonds anyway?

If you have a long enough investment time horizon stocks generally provide higher returns than bonds.  However, owning a portfolio of only stocks can result in your portfolio experiencing significant volatility in value over the short term.  Many investors find such fluctuations too difficult to swallow.  Besides reducing the overall impact of stock market fluctuations, bonds provide ammunition to buy stocks when they are down.  Bonds also generate regular income for your needs at a time when you might not otherwise want to sell some of your stocks.

What is a bond?

A bond is a loan to an issuer (such as a government or corporation) who promises to:

  • pay you a specified rate of interest during the life of the bond, and
  • repay the face value of the bond (the principal) when it “matures” or comes due.

There are a number of variables to look at when investing in bonds. The four main ones are credit quality, interest rate, time to the bond’s maturity and redemption features.  These things help determine the value of your bond investment, and the degree to which that value matches your financial objectives.

 

Bond characteristics

  1. Credit quality of issuer

Bonds range in quality, based on the likelihood that the issuer will be able to make the regularly scheduled interest and principal payments.

Most corporate bonds are really debentures. That is, they are unsecured debt obligations backed only by the issuer’s general credit and the capacity of its earnings to repay interest and principal.

Credit quality can be improved if the issuer secures the loan with an adequate amount of collateral.  Or it can be improved if the bond is guaranteed by a corporation or government with a better credit rating than the issuer.

Credit ratings are a key tool for an investor who wants to know how strong a company’s unsecured bonds are.

 

Chart 1:  Credit Ratings

Credit Risk Moody’s Standard & Poor’s DBRS
INVESTMENT GRADE
Highest quality Aaa AAA AAA
High quality Aa AA AA
Upper medium grade A A A
Medium grade Baa BBB BBB
NOT INVESTMENT GRADE
Somewhat speculative Ba BB BB
Speculative B B B
Highly speculative Caa CCC CCC
Most speculative Ca CC CC
Imminent default C C C
Default C D D

The higher the credit rating, the greater the creditworthiness of the company and the greater the chances that the company will be able to make its scheduled interest and principal payments.

 

  1. ‘Coupon Rate’

The coupon rate is the interest rate a bond will pay each year.  Bonds pay interest that can be fixed, floating, or payable at maturity (a “zero-coupon bond”).

Most bonds have a coupon rate that stays fixed until maturity.  This rate is normally expressed as a percentage of the face (principal) amount.  Typically, investors receive interest payments semi-annually.

For example, a typical bond with a face value of $1,000 at a 6% coupon rate will pay investors $60 a year, in payments of $30 every six months.  When the bond matures, the investor will receive the final interest payment plus the face amount of the bond.

The coupon rate on a floating-rate bond is reset periodically in line with changes in a base interest rate index, such as the Prime Rate.

Some bonds have no periodic interest payments.  Instead, the investor receives one payment at maturity. This payment is equal to the purchase price (principal) plus the total interest earned, compounded semi-annually at the (original) interest rate.  Known as zero-coupon bonds (or “coupons”), they are sold at a discount from their face amount.  They are like a compounding GIC.

For example, a bond with a face amount of $20,000 maturing in 20 years might be purchased for about $5,750.  At the end of the 20 years, the investor will receive $20,000.  The difference of $14,250 between $20,000 and $5,750 represents interest.

If the zero-coupon bond is held in a non-registered account, interest is taxed as it accrues each year even though no interest is actually received before maturity or redemption.

 

  1. Maturity

A bond’s maturity refers to the specific future date on which the face amount (or principal) will be repaid.  Bond maturities typically range from 1 year to 25 years.  Maturity ranges are often categorized as follows:

  • Short-term notes: maturities from 1 to 5 years;
  • Intermediate-term notes/bonds: maturities of 5 to 10 years;
  • Long-term bonds: maturities greater than 10 years.

The longer the term to maturity, the longer time you are faced with the default risk and the more time your principal is impacted by an erosion to inflation.  For this reason, the longer the time to maturity, the higher the amount of interest you would want from the bond.

  1. Redemption features

The maturity period is a good guide as to how long the bond will be outstanding.  But certain bonds have structures that can substantially change the expected life of the investment.

For example, some bonds have a “redemption” or “call” provision that allows the issuer to repay the face amount at a specified date before maturity.

Bonds are commonly “called” when interest rates have dropped significantly since the time the bonds were issued.  So, in order for redeemable bonds to be attractive to investors, the bond document normally allows such redemption but at a stated price greater than the face amount.  Otherwise, bonds with a redemption provision would have to be offered at a higher annual return to compensate the investor for the risk that the bonds might be called early.

Although less common than redeemable bonds, some bonds have a “retraction” or “put” feature.  This gives the investor the option of requiring the issuer to buy back the bonds at specified times before maturity.  An example of a retractable bond is the Canada Savings Bond – it is redeemable on demand by the registered owner.

 

Bond price fluctuations

From the time a bond is originally issued until the day it matures, its price in the marketplace will fluctuate.  It does this according to changes in 1) market conditions (ie: interest rates) or 2) credit quality of the issuer

  1. Changes in interest rates

Bond prices will fluctuate with every change in interest rates in a predictable way.

When interest rates rise, prices of outstanding bonds fall.  This brings the yield of older bonds into line with higher interest rates of new issues.

Let’s say you bought a $1,000, 6%-bond maturing in 5 years.  This bond will pay you $30 every six months until maturity.  Should interest rates increase to 7%, investors would be less interested in your bond since they can buy a newly issued bond for $1,000 which will pay $35 every six months.  In fact, the value of your bond will drop to $958.42 which is the point where an investor would find your bond and a newly issued 7%-bond equally attractive.

If, on the other hand, interest rates fall, prices of outstanding bonds will rise until the yield of older bonds is low enough to match the lower interest rate on new issues.

Changes in interest rates don’t affect all bonds equally.  The longer the time to maturity, the greater the effect of a change in interest rates on the value of a bond. (see Chart 2)

Chart 2:     Impact of the value of a bond
when interest rates rise

 

  5 year bond 10 year bond
Principal $1,000 $1,000
Semi-annual coupon $30 $30
Bond value:    
6% interest rate $1,000.00 $1,000.00
7% interest rate $958.42 $928.94
Change in value $41.58 $71.06

Chart 2 shows a 1% increase in interest rates results in a loss that is $29.48 greater for the 10 year bond than the 5 year bond.

 

  1. Credit quality of the issuer

If the financial situation of an issuer deteriorates, this may result in a credit rating agency, which monitors the issuer, to review the company’s credit rating.  A lowered credit rating generally results in a lower value of the issuer’s bonds.

 

‘Current yield’ and ‘Yield to maturity’

Current yield is the annual coupon interest return on the dollar amount paid for the bond and is derived by dividing the bond’s interest payment by its purchase price.

If you bought a bond at $1,000 and the coupon rate is 6% ($60), the current yield is 6% ($60 ÷ $1,000).  If, instead, you bought a bond for $900 and the coupon rate is 6% ($60), the current yield is 6.67% ($60 ÷ $900).

Yield to maturity is much more meaningful as it tells you what your total return will be if you hold the bond until maturity.  It factors in: a) the coupon interest you receive each year, plus b) any gain (if you purchased the bond below its par, or face, value) or loss (if you purchased it above its par value).

So, if you buy a 5-year, 6% bond for $958.42, the bond’s current yield is 6.26% (= $60 coupon interest / $958.42 purchase price).  However, the current yield doesn’t take into account the $41.58 capital gain you will realize on the bond’s maturity.  By taking both parts together, the bond’s yield to maturity (which includes coupon interest and the capital gain) will be 7%.

 

Fixed income investment strategies

Our approach to bond investing has been to divide the monies available for fixed income investments into two parts: a fixed income ladder, and a portfolio of high income investments.  This approach is a buy-and-hold method to fixed income investing.

 

1. ‘Fixed Income Ladder’

Studies have shown that holding government guaranteed bonds in a mutual fund tends to underperform by the amount of the management fees.  As such, we prefer to buy and hold individual government bonds or coupons.   To minimize the re-investment risk at bond maturity, we use the “fixed income ladder” strategy.

A fixed income ladder is where roughly equal dollar amounts are invested in government guaranteed bonds or coupons.  Maturity dates are staggered to mature one year, two years, three years, four years and five years from now. Example: $50,000 is divided into five $10,000 amounts maturing from one to five years from now).

Each year when a bond matures, the proceeds are used to buy a five-year bond.  This “ladder” reduces re-investment risk since only 1/5 of your bonds mature in a year.  Also, by investing each year in a five-year bond, your ladder will eventually generate a return close to that of a five-year bond rate.  So, through time you have less risk at a comparable return to that of just owning a single five-year bond.

Where you are retired and need cashflow from your portfolio, we want to guarantee five years of your living needs.  The last thing we want to do is sell some stocks to meet needs when the market is down making a temporary loss permanent.  So instead of buying equal dollar amounts of bonds each year, we’ll buy amounts to mature in an amount to match each year’s living needs.

The magic of guaranteeing five years of living needs is that if the market does drop, five years is normally a long enough period to allow a stock broad market index or a well-diversified stock portfolio to recover.  For many investors, guaranteeing five years of needs provides them with peace of mind and an ability to think and invest with a long-term perspective.

 

2.  Replacement to the Fixed Income Ladder Strategy

With the significant drop in interest rates, the yields on bonds maturing 5 years or less has been reduced to levels that don’t even keep up with inflation.  For example, a five year Government of Canada bond today has a yield to maturity of about 1%.  So, during this period of extraordinarily low interest rates, we aim at having one year of living needs in a bond mutual fund that pays out each month the amount you require for your living needs.  From the remaining portfolio investments, the interest and dividend income that is generated is added to the bond pool so that it maintains having one year of your living needs within the fund.

The remaining amount of monies available for fixed income investments are invested in a diversified portfolio of higher yielding bond investments (actually these are typically corporate debentures).  Here we ideally would strive to buy 20 or more individual bonds or debentures.

In addition, might include a high yield bond pool (either a fund or exchange traded fund containing more than 100 low quality bonds with high yields).  Studies have shown that these high income funds have given returns close to those of the the stock market but have done so with less risk.

 

The next step

If you only have bond funds it may be time to consider switching to another investment advisor.  To get a no-obligation second opinion of your portfolio, please call me at 604-288-2083 or email me at steve@lycosasset.com.

 

 

Written by Steve Nyvik, BBA, MBA ,CIM, CFP, R.F.P.
Financial Planner and Portfolio Manager, Lycos Asset Management Inc.

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