Saturday, December 29, 2018

Investing in Bonds – the right way

Treat your bond investments as if they are GICs and hold them until expiry!

People look down on GICs with their low interest rates. Bond yields are even iffier. We all worry about capital losses in long term bonds, and when you invest in medium to long term bond ETFs which tend to trade in and out of those bonds, then I think that that worry is justified. But what is a bond?

A bond is a loan to a corporation or to a government of a country or to a provincial government. Say we give a 10 year loan to the government of Canada. The first question you ask is what the chance is to get your money back? This is for Canada pretty good; AAA rating. Next you ask how much interest does the bond earn? If it is a bond newly issued by the Government of Canada then you do directly lend principal (face value typically $100 per bond) to that government for a coupon interest rate.  

You must know that the loan or bond you gave to the Government of Canada is tradeable: there is a resale or bond market. Over the last 3 months, the yield (that is the amount of income you receive per year divided by the purchase price of the bond) ranged from 2.4 to 1.9%  [Never forget that after inflation and taxes you have often a negative ‘real’ return – against that your TSFA or RRSP may help]
Suppose, in October you gave a loan (bond) to the Government of Canada that expires in 10 years with an interest income of $2.40 per year for a face value of $100. In October you could instead have bought a Government of Canada bond in the resale or bond market, yielding $2.40 for $100 worth of Government of Canada bonds. A question may be what you should pay for that bond when the yield in December for such a bond is $1.90?  The answer is that to earn $2.40 you would need to own 1.263 bonds that pay $1.90.  As such, you would need to pay for the $2.40 bond $123.60 in order for it to yield $1.90 per $100 worth of bonds.  In other words, the owner of the 2.4% yielding bond who paid $100 for his/her bond in October should receive $123,60 for that bond if he sold it in December. Nice capital gain! But… that is on the assumption that the bond or loan would never expire!  If there is an expiry date then you would have to take the bond’s cash flow from purchase until expiry including the face value of the bond and calculate its Net Present Value.  The face value of a bond is the amount of money lend to the government (typically $100) when issued and which is due upon redemption at the expiry date.

Thus the price at which you can buy a bond in the resale or bond market with $100 loan face value and a fixed interest rate (coupon rate) over a certain term, e.g. 10 years, varies over time until redemption at the loan’s expiry date. Many bond traders buy bonds prior to expiry based on yield, expiry date and market price; the latter representing the Net Present Value with the prevailing yield at the time of purchase. But what if you buy a bond with a certain yield and a term of 10 years that you redeem upon expiry? 
In that case, you are buying a bond that behaves as a 10 year GIC with an interest rate equalling the yield of the bond and that in part is payable as interest (face value of the bond x coupon rate) and part as a capital gain or loss at redemption. As long as you don't sell that bond there are no further capital gains or losses. If you bought the bond for a tax sheltered RRSP or TSFA there is no difference with a GIC other than that your duration – with bonds the time until expiry - can vary from days to decades, while the range of GIC terms is very limited. Also, when dealing with Government of Canada bonds you don’t have to worry about Federal Deposit Insurance (FDIC) as it is inherent. Most GIC rates are for up to 5 years and range today in interest rate from 3.65% at EQ Bank to as little as 1.6% at one of Canada’s big 5 (Scotia Bank).

How do you buy a bond? You can buy them through a discount broker (look for ‘fixed income’) or through your full service broker. GICs you can buy through brokers (including GIC brokerages) or banks and other financial institutions. Ensure the GIC has FDIC insurance!

If you buy a bond and hold it until expiry then your income is fixed and it behaves just like a GIC with the same expiry. And thus you have only to ask yourself what yield (now equalling a GIC’s interest rate) you have. Make sure you hold both bonds and GICs in a tax sheltered account. If you own bonds rather than GICs there is a bit of an advantage in that it will smooth your portfolio volatility because its trading value typically goes up during a stock market crash. With the bond you always have the option to sell prior to expiry! In case of a GIC you are most likely to pay a nasty penalty if you want your money prior to expiration.

The older you get the more certainty you may want about getting a fixed minimum monthly income and thus you can use GICs or bonds to help you achieve that combined with your Canada Pension and OAS payments. There are of course tax implications but if you keep your non-tax sheltered income to a minimum (using RRSP or TSFAs), you can often keep your income taxes low. You can also do that after age 70 but now you must use a RRIF instead of an RRSP account. A Registered Retirement Income Fund (RRIF) requires a minimum monthly withdrawal regardless of your taxable income which can be annoying. As always, the government taketh or taketh more!
What the interest rate outlook is for the coming years is extremely uncertain. North American interest rates may head up for now; the real question is for how long and by how much? Don’t forget that higher rates mean higher deficits because the government has to pay more to finance its debts. Thus there is definitely a head wind as far as higher interest rates for savers are concerned. Other lenders, such as corporations, also prefer low interest rates to keep profits up. Thus investors in fixed income are at a definite disadvantage but there is security of income (depending on the credit worthiness of to whom you lend).

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