Should you bond with bonds?
Every day, some $5 billion of stocks trade hands in Canada. That’s a lot of money.
But what trades about ten times as much dollar volume every day?
The Canadian bond market is many times the size of the stock market, and its trading trends can help determine mortgage rates, the level of the Canadian dollar, and the rates of return on many of your mutual funds. Yet the daily trading results attract much less attention.
As the name suggests, a bond is a promise. It represents a commitment from a user of capital (a borrower) to repay an investor (a lender or provider of capital) a fixed amount of interest for a fixed term, and then to repay the principal at an agreed later date.
Bonds are issued by governments, municipalities and corporations. You are likely familiar with Canada Savings Bonds, and Manitoba Builder Bonds. These savings bonds do not generally trade everyday in what we call the “bond market”. They are typically held to maturity.
Builder Bonds are available now until June 5th. The rate on the five-year floating bond is 1.75% for the first year. The three-year fixed bonds pay 1.85%, and the five year pays 2%. The following comments do not apply to them.
Corporate bonds sometimes have variations or “sweeteners”, like the right to convert the bond to the stock of the same issuer at a pre-determined price, or the ability to redeem early or to extend the term. Some bonds have been “stripped”, with the principal portion separated from the interest or coupon portion. These do not pay regular interest, but simply mature in the future at a higher value. The growth, however, is taxed as interest income.
The “coupon” is the amount of interest agreed to be paid, calculated on an assumed face amount, typically $100 when issued. If the coupon rate on a bond is 5%, then $5 of interest will be paid each year on each $100 of face amount.
Once bonds have been issued, they then trade on the secondary bond market – an electronic web between bond traders, who ask a certain price for different bonds they own, and bid for bonds they want to buy.
So, what if the bond market rallies, prices rise, and that $100 bond is now trading at $105?
This is where it gets interesting. When the news report says “the bond market is up today” it means prices are up. People who own bonds made money that day.
However, people who want to buy bonds the next day have to pay a higher price. Since the interest being paid on those bonds is fixed, a higher price actually means a lower percentage interest rate.
“Yield” is the interest rate to be earned on a bond at its current price. When bond prices go up, yields automatically go down.
If that 5% bond is now trading at $105, then the actual yield is now the $5 coupon, divided by price ($105) times 100 = 4.76%.
Also factoring into your investment decision is the fact that the bond will mature at $100 in the future, which means a 5% capital loss from your $105 purchase price. In this case, the actual yield-to-maturity of a 10-year bond paying $5 per year interest, purchased at $105 is about 4.37%, if all interest payments are also reinvested at 5%.
If you can buy a lower coupon bond at a discount, and you receive less interest and a guaranteed capital gain, that’s a better strategy.
Bond prices are much more stable than stock prices, the interest rate is guaranteed and bonds rank above preferred shares or common stock if the issuing company is liquidated. Bond prices tend to go up when there is bad news for the economy, because that bad news typically means slowing economic activity, a future drop in inflation and no pressure on interest rates to rise.
Therefore, bonds will often rise when stocks fall, making them a very useful stabilizer in a portfolio. However, they do have short term risk, and can fall significantly in price if interest rates rise suddenly, or if the bond market suddenly perceives that inflation and higher interest rates are on the horizon.
An excellent strategy is therefore to set up a “ladder” of bonds, with bonds maturing each year. If you hold them to the guaranteed maturity value, then you can ignore the short term price fluctuations.
Mutual fund managers use many strategies to increase the return on bonds. ETFs are available which simply mirror the returns on one of the bond markets (corporate, high yield, government or all three).
To buy individual bonds, you need an account with an investment dealer. As with everything, small purchases are not priced nearly as well as large ones, so institutional rates are much better, meaning it is sometimes worth it to pay a (reasonable) management fee to a professional bond manager, rather than try and manage the portfolio yourself.
For detailed study, purchase Andrew Allentuck’s 2007 book Bonds for Canadians, or In Your Best Interest, by W.H. “Hank“ Cunningham.
* * *
This information is meant as an introduction to this topic and should not in any way be construed as a replacement for personalized professional advice.