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Investing

Pleased to meet you, Mister Bond

March 27th, 2013 by ,    photos by Sean Connery as James Bond

Bonds may not be the most exciting investments, but they can be the workhorses of a balanced portfolio. Here's the lowdown on bonds, plain-English style...

 
 
 

While the subject of bonds - and fixed income investments in general - might not be as exciting as the suave Aston Martin-driving action hero, they nevertheless play an important role in balancing your personal investment portfolio. However, you might not be aware of all the pitfalls that bond ownership brings. Believe it or not, bonds can be risky investments, particularly if you don’t understand their complexities. Here are a few things to keep in mind when considering bonds for your portfolio.

The bond basics

When you buy a bond, you are lending money to a government, agency, or a company. These entities will pay you interest on the amount you loaned them over a fixed period of time. You will typically collect this interest either every six months or every year. At the end of the loan period, you get your money back.

Don’t take these coupons to the grocery store

The way a bond works sounds simple enough, right? The tricky part is learning what the jargon means. The most common way for you to receive interest payments is in the form of coupons. A coupon in the world of fixed income is a single fixed-interest payment. For example, you may hear about a bond that simply pays an annual coupon of 3%. What this means is that you will receive 3% in interest on the value of the bond once per year. The same bond can also pay you on a semi-annual basis, so you will receive 1.5% every six months. The nice thing about semi-annual payments is that you get more compounding power working to your benefit.

Not your typical department store discount

The value of a bond is called its price.  This is where things can get a bit confusing. Although governments borrow billions of dollars from their citizens via bond instruments, each bond is generally divided into smaller units. The par or face value of a bond is typically $1000. However, when you buy a bond, you may not hand over the entire $1000. Instead, the current price could be $960. At the end of the term of the bond (called its maturity date), the government is obligated to pay you, the bond owner, the par value of $1000. The $960 you paid is known as the bond’s market value, and the extra $40 you earn on the $960 investment is called the bond’s discount.

What the heck is yield-to-maturity?!

As if things haven’t gotten complicated enough, we run into the term Yield-to-Maturity (YTM). To translate this into plain English, YTM is the interest you’ll actually earn if you hold the bond to maturity. Essentially, YTM is the interest rate you’ll earn when you take into account the bond’s coupon, its discount, and its lifespan. For example, let’s say we come across a bond with these characteristics:

  • its market value is $960, with a par value of $1000
  • it has an annual coupon of 2%
  • it has a maturity date of 10 years from now

At the end of this 10-year period, you will have received an extra $40, plus the 2% coupon paid to you each year. This comes out to an annual YTM rate of 2.46% (you can do this same calculation yourself here). This means that you will earn 2.46% per year over 10 years on your investment of $960. Note that this is slightly higher than your annual coupon rate, which is a result of the extra $40 you earned on the bond’s market value. (CRA tax tip: The extra $40 is treated as capital gains for income tax purposes.)

Why you should care about YTM

A lot of people confuse coupon interest for YTM, and as you can see, they are very different things. The reason why this is a problem is because sometimes the market value of a bond is higher than the par value. Here’s another bond and its characteristics:

  • its market value is $1040, with a par value of $1000
  • it has an annual coupon of 2%
  • it has a maturity date of 10 years from now

The YTM on this bond is 1.56%. Notice that this is lower than the coupon rate of 2%. Herein lies the problem: When we look at only the coupon, the interest rate looks reasonable at 2%. However, the truth is you paid a premium on the bond of $40, which means that at maturity, you’re going to get back $40 less than what you put in (because you will always receive the bond’s par value of $1000 at maturity). Therefore your annual return becomes less attractive. (CRA tax tip: The $40 is treated as a capital loss.)

Stirred, not shaken

A bond’s price will fluctuate over its life. This will stir the value in your portfolio periodically, adding to its volatility. However, do not be shaken by this (bad pun, we know). Typically, the volatility in fixed income investments is about half that of the stock market. This means that you can comfortably hold onto a bond if you’re happy with its YTM.

The darker side of bonds

Governments of the world have been artificially holding interest rates down for years. They’re doing this to help stock market investors and the economy overall, but this comes at the expense of fixed income investors like bondholders, who are receiving coupon payments that are close to or below current inflation rates. What will happen to these investors when inflation rates rise in the future? Tune in next week for our discussion on the risks associated with investing in bonds.  

 

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