Talk stocks with your friends and they’re all ears. Talk bonds and their eyes glaze over. Why? Because stocks are stories—about exciting new products or projects and the people behind them. Contrast that with bonds, which are considered boring and even a little stodgy.
While bonds rarely make headlines, they’re an extremely important part of almost all portfolios. Yet many investors have only a vague understanding of how they work. Some of the ideas can be complicated, we’ll admit. But when boiled down to their essence, bonds are relatively straightforward investments.
Think of a bond as a kind of loan. When you buy a bond, you give a government or corporation a sum of money in exchange for the promise of interest payments for a specified period. At the end of that period—when the bond matures—the interest payments stop and your initial investment is returned to you.
To understand the details, you need to learn bond market jargon. A federal government bond might be described as having a face value (or par value) of $10,000, a coupon of 3% and a term to maturity of five years. If you purchase this bond for $10,000, you’ll receive $300 in interest every year for five years. (Most bonds have semi-annual coupons, so you’ll receive $150 every six months.) When the bond matures in five years, you’ll get your original $10,000 back.
Sometimes bonds sell at prices higher or lower than their face value—that is at a premium or a discount. When you divide the annual coupon payment by the bond’s current price, you get its yield.
What’s their role?
In days gone by, bonds were stable sources of income. I remember the early 1980s, when 10-year government bonds yielded more than 16%. It was a different time—heck, bell-bottom pants were still in style. Even during the decade before 2008, the yield on 10-year Government of Canada bonds ranged between 4% and 6.5%. At those levels, they could be relied upon for a reliable, if modest, income stream.
The global financial crisis of 2008–2009 changed things. Since then, central banks have driven down interest rates to historic lows. In many cases the yield on safe bonds like those issued by the federal government don’t even keep up with inflation, never mind provide income one could live on.
As a result of the low interest rate environment, bonds today are primarily a portfolio diversifier. The big returns may be gone, but bonds still dampen the volatility of equity portfolios. For example, when equity markets crash, money flows out of stocks and into safe havens like high-quality bonds, which drives their prices up. That helps offset some of the losses on the other side of your portfolio.
This diversification benefit is the reason why investors should think carefully before abandoning bonds because of their low yields. Other investments are often touted as a substitute for high-quality bonds, including dividend stocks, preferred shares, real estate investment trusts (REITs) and high-yield bonds. These may indeed provide reasonably secure income streams. However, investors need to be aware that in a crisis these assets will likely lose value along with the broad stock market: in 2008–2009, all these asset classes suffered double-digit losses. Government bonds, on the other hand, rose significantly in value. Creditworthy bonds are a safety net, and the price of that safety is low yield.
Understanding bond risk
When choosing bonds for your portfolio there are only two factors you can control: maturity and credit risk. As with any investment, you should expect to be compensated for taking on extra risk: if the issuer is not going to repay you for a long period or if there is a risk they might not repay you at all, you might justifiably demand more interest on the loan. Not only would this make you more comfortable lending the money, but it would also ensure you’ll recover at least some of your loan.
A bond’s maturity date is when the face value (your principal) is returned to you. In general, the further away the maturity date, the greater the risk, and therefore the higher the interest rate investors demand. That’s why a 20-year bond carries a higher coupon than a five-year bond.
Credit risk is the probability you’ll collect interest on your investment and have the principal returned on maturity. For example, bonds issued by the federal government carry far less credit risk than those issued by a corporation with a troubled balanced sheet. The corporate bond, therefore, will pay a higher coupon to compensate investors for the additional risk.
Bond investors need to consider the types of risk they’re willing to accept. You might be comfortable with the lower yield of a government bond if you’re investing for a long period. Conversely, a riskier bond might be okay as long as it’s not for too long and the yield is attractive.
Bonds can be volatile
Although high-quality bonds can provide a safety net, investors must be aware that bond prices go up and down—though not with the same volatility as stocks. And they move in ways that aren’t intuitive: bond prices go down when interest rates go up, and vice versa.
Imagine a schoolyard teeter-totter, with one end representing a bond’s price and the other end its yield. If you sit at the “price” end and someone larger sits at the other end and forces the “yield” down, then you’ll go up. It works both ways: higher yields go hand-in-hand with lower prices.
To understand why, let’s look at an example. Suppose an investor buys $1,000 of a 15-year bond with a 4% coupon, which pays $40 in annual interest. Soon after, the going rate on similar bonds rises from 4% to 4.5%. To be competitive in the marketplace, the bond’s yield would need to change or no investor would want the bond. In this example, the price of the bond would drop from $1,000 to about $946, a decline of 5.4%. Investors may not think half a percentage point is a big move in interest rates, but the result is a significant drop in the price of this bond. A one-percentage-point change in rates would cause a move of almost 10.5 percentage points in this bond’s price!
We used a 15-year bond in the above example, and long-term bonds like this are more sensitive to changes in interest rates. Bonds with terms less than five years won’t rise or fall in value as sharply when rates move. For example, consider the same bond as above, but with a term of just three years. If rates on comparable bonds rise by half a percentage point, the bond would fall in value to about $987, for a loss of only 1.3%.
Interest rates are going up—or are they?
Why buy bonds at all if you think interest rates are going higher and prices will go down? There are two reasons, actually.
First, do you know for certain that rates are going up? So-called experts have been saying interest rates are certain to move higher for four years now—and they’ve been mostly wrong. Rates did move higher in mid-2013, but they’re lower today than they were in early 2010.
Interest rates typically rise when the economy is booming and investors feel secure. Does that describe the current environment? China’s growth is still in question. Europe is still a mess. The American government has a hard time getting its act together. Global stock markets (especially the U.S.) have climbed to new heights and could be due for a correction. Seems to me there are lots of reasons why rates may not go higher.
Second, suppose rates do indeed go up. That would cause bonds to fall in value temporarily, but if you’re saving for retirement and planning to put money into bonds for the next 10, 20 years or more, rising interest rates should be should viewed as a good thing: every time a bond matures, you’ll be able to invest the proceeds in new bonds with higher yields.
Putting a plan in place
Now that you understand the benefits and risks of bonds, let’s consider the two main strategies for using them in your portfolio, each with its pros and cons: laddering and investment funds.
Laddering involves buying a series of bonds with ascending maturities. Say you have $100,000 to invest. You might build a 10-year ladder by investing $10,000 in a bond with a one-year maturity, another $10,000 in a two-year bond, and so on until you have 10 bonds with an equal amount in each maturity “rung.” Each year, one of the bonds will come due and you can reinvest the proceeds at the longest end of the spectrum—in this case, in another 10-year bond—that carries the highest rate.
This is an excellent way to spread out interest-rate risk and keep volatility low, since you always hold a range of maturities. If interest rates rise, you’ll be able to reinvest a portion of your money at the new higher rates every year. A bond ladder also allows you to earn a predictable stream of income, so you can plan for future liabilities.
But here’s the rub: a bond ladder is a good option only for large amounts of money. Individual bonds are sold in multiples of $1,000 and often are not readily available in small denominations. Even if they are, retail investors have a hard time getting decent pricing when purchasing relatively small amounts. This makes the laddering strategy more suited to retirees who have accumulated a lot of assets. It also helps to work with an adviser who is able to negotiate better bond prices than you would get from a discount brokerage.
A better way to add bonds to your portfolio with a relatively small investment is to use an investment fund. Whether you opt for a low-cost, actively managed bond mutual fund or a passively managed ETF, there are several advantages. First, rather than building a ladder with five or 10 moving parts, you can have a diversified bond portfolio with a single holding. It’s also easy to add money if you’re in the process of accumulating a nest egg, and you can readily buy or sell units of the fund whenever you’re rebalancing your portfolio.
The downside is most bond funds don’t have a maturity date, so you can’t rely on a known amount of money being available on a specific future date. A fund’s holdings change over time, so income streams are less predictable.
Bonds should play a stabilizing role in a portfolio and you want to be able to adjust to potentially rising interest rates. So investors should look for a fund with shorter-maturity bonds with strong credit profiles.
One simple approach is to buy an ETF tracking an index. The Vanguard Canadian Short-Term Corporate Bond Index ETF (VSC) includes 200 investment-grade bonds issued by Canadian companies (mostly banks) with maturities under five years. The MER is just 0.15%, an important consideration when yields are as low as they are today. If you prefer the additional safety of government bonds, the BMO Short Provincial Bond ETF (ZPS) has a management fee of 0.28%.
There are even ETFs that use a laddered strategy. The iShares 1-5 Year Laddered Corporate Bond Index Fund (CBO) holds a portfolio of bonds—mostly offered by banks and life insurance companies—structured in five maturity rungs. And RBC Asset Management has seven corporate bond ETFs that mature between 2014 and 2021.
The potential disadvantage of ETFs is they’re passive investments: perhaps it’s worth having a professional bond manager take a more active approach. That’s where more traditional mutual funds come into play. There are 140 short-term Canadian bond funds but once we filter for good performance and low costs, Phillips Hager & North quickly pops out. PH&N has been around for 50 years and has a stellar reputation for prudent management and low cost, especially in bonds.
Paul Samuelson, a Nobel laureate in economics, once said “investing should be more like watching paint dry or watching grass grow. If you want excitement, take $800 and go to Las Vegas.” Remember that as you monitor your portfolio: bonds should be boring. You’ll never hit a ten-bagger you can brag about at parties. But if you understand how to use them wisely in diversified portfolios, bonds can help you achieve solid investment returns with a minimum of volatility. And that’s the best investment story there is.