Investing in Bonds

The topic of Investing in Bonds is a very broad subject area. It is also a topic about which most retail investors know very little.

This article provides an introduction to the topic.

Bonds are investments that pay interest every 6 months (or 12 months in some cases) and that return the face value of the bond on the maturity date of the bond.

Bonds are issued or sold by governments and corporations. After they are issued, bonds typically trade in the market (more about that below).  At the issue date, bonds have maturity dates that are at least 2 years in the future and the maturity date can be 30 or more years into the future. The face value of a bond is usually $1000.

Most retail bond investors invest in bonds with a goal of collecting a return through interest payments while desiring to incur very little risk.

Unfortunately, the only bonds available to Canadian investors that are essentially without risk are Canadian Federal and Provincial government bonds with about two years or less until maturity.  The unfortunate aspect is that Canadian Federal Government two-year bonds currently yield only 3.24%. This is a very small return, particularly when held in taxable accounts. However, it is better than nothing and is a guaranteed return. Investors that cannot afford any risk whatsoever for a two year holding period may find that this is the best available no-risk return.

Higher Bond yields can obtained either by investing in corporate rather than government bonds , or by investing in longer term bonds, or a combination of both.

10-year Canadian government bonds currently offer a yield of 4.32%, while 30-year Canadian government bonds currently offer a yield of 4.74%. This is an incremental annual return of 1.08% and 1.50% as compared to the 2-year government bond. While the extra return is attractive it comes at the cost of significant risk to principal value if market interest rates should rise. This
is of concern because retail bond investors typically are looking for a very low risk investment.

If market interest rates were to jump by 1% our 10-year government bond would immediately drop in value by about 7.6% while the 30-year bond would immediately drop in value by about 14.2%. If interest rates climbed by 2% then the 10-year bond would drop by 14.5% while the 30-year bond would drop by 25.5%. These are significant losses when one is looking for a no-risk investment! And the losses get worse if interest rates should jump by more than 2%. An increase in long-term interest rates of 2% may seem unlikely at this time but it is certainly feasible particularly over the long life of these bonds.

Some will argue that these are not real losses since the investor will still receive the expected interest rate payments and ultimately the maturity value of the bond. But the reality is that a loss in market value of the bond will occur. The investor’s monthly statement will show this loss. It’s questionable whether the added risk of longer term bonds is justified by the extra 1 to 1.5% return.

The second way for bond investors to boost return is to invest in corporate bonds rather than government bonds. High-grade corporate bonds (those with credit ratings of A- or higher) of two years duration can offer returns that are about 0.25 to 0.50% higher than the federal government two-year bond yield. This is only a small boost in return but the risk of default on a two -year high-grade corporate bond would be considered very low. The excess return on corporate bonds over the equivalent term federal government bond is called the “spread”. The “spread” on corporate bonds increases with longer maturity levels.

the corporate “spread” or incremental return also increases with lower credit ratings. For higher risk corporations the spread can easily be 4% or more butthe risk also increases sharply.

Retail investors who are looking for low risk bond investments should restrict themselves to government bonds and high-grade corporate bonds and should also probably restrict themselves to maturities of five years or less.

Retail investors can purchase bonds through their broker. This is an area where a full-service broker can be quite advantageous. Bonds can be purchased through discount brokers, but the discount broker is unlikely to provide any advice.

Bond investing, implies a buy-and-hold approach. Bonds can also be traded on a short term basis. Click here for a short introduction to Bond Trading.

Shawn Allen,CFA, CMA, MBA, P.Eng.
President, InvestorsFriend Inc.
April 9, 2005