Sunday, 23 September 2012

Investing 101: Bonds

Let's talk about what to do with all that money that you've worked so hard on saving up. In this section titled Investing 101, I'll go over different terms and ideas that every investor should know. Hopefully the information provided will help give you a general idea of how things work and build a foundation for you to go and further educate yourself. Welcome to class. Today's topic? Bonds.

A bond is essentially an "I.O.U." written by either governments or companies. They all issue bonds in order to raise capital and there are numerous reasons that they may need the cash such as using it to fund the purchase of another company, using it to pay off debt that's coming up... or maybe even to help bail out the country.

Regardless of what the money is used for, the question is: what does the bondholder get in return? Loaning your hard-earned cash for free doesn't sound like a good idea, so to compensate bondholders, they will receive interest.

This is very similar to a Guaranteed Investment Certificate (GIC) which is essentially a bond that you can't sell. Both are I.O.U.s with an expiry date which can range anywhere from a couple months to decades!

Why would an investor choose bonds over stocks, especially since 100% of the interest is taxed while capital gains and dividends received with stocks are taxed more favourably? Well that's a great question my intelligent reader.

One of the reasons people hold bonds is that they see them as "safer" investments. Bonds are less volatile and if the company goes belly-up, then the bondholders get first dibs on all the assets to try and recoup their money while the shareholders get the scraps. Government bonds are "safe" because they can always raise taxes to generate cash to pay for their bonds (this is one of the reasons that corporate bonds offer a higher coupon - they are generally seen as riskier than government bonds because they can't raise taxes). Even though it's unlikely to lose your principal in bonds, it may not necessarily be "safer"; if the coupon is less than inflation, then your dollar amount may stay the same, but the buying power is shrinking, so you're still come out behind.

A major relationship that potential bondholders need to understand is the price of a bond and the interest rates set by the country. The coupon is determined based off the prime interest rates set up by the government. For example:

The government offers a 5-year bond with a 3% coupon based off the prime interest rate.
This means that corporate bonds will need to offer a slightly higher coupon due to them being riskier.
I'll purchase a government bond and be happy with my 3% yield but if for some reason I needed the money, I can sell it and get my principal back no problem.

Now let's see what happens when the government decides to raise interest rates:

The government offers a 5-year bond with a 4% coupon based off the prime interest rate.
This means that corporate bonds will need to offer a slightly higher coupon due to them being riskier.
What happens to my old bond that yields 3%?

Since bonds can be bought and sold just like stocks, would anybody buy my bond from me for the same price that I paid for it? It's clearly a bad deal for the buyer because they can use the same amount of money and buy a new bond with a 4% coupon instead of getting a 3% coupon. Due to this reason, my old bond is worth less on the market; in other words it trades at a discount. If I really needed the money, I would have to sell it for less then what I paid or else nobody's going to bite. The opposite of this (rates going down so bond prices going up) would result in the buyer paying a premium for my bond since it's worth more than what he can get if he buys a brand new bond from the government.
If I held it to maturity (i.e. I just sat on the bond for the next 5 years) then I would be able to get my principal back along with the 3% interest so if I don't plan to sell my bonds then fluctuating interest rates are of no concern to me. However, there are many people who trade bonds to make profit and even the slightest indication of a rate change from the government can have huge impacts on the bond market. Bonds with smaller dates to maturity (ex. 3-year bonds) are more sensitive to rate changes then ones with larger dates to maturity (ex. 10-year bonds).

One way to mitigate risk is to create a bond ladder. This is when you split up the amount of money you would like to invest into equal parts and buy bonds with different maturities. For example:

I have $5000 I would like to invest, so I buy 5 bonds with maturities of 1 year, 2 years, 3 years, 4 years and 5 years, each worth $1000. By doing this, only 1/5 of my investment is exposed to changing interest rates at a time. Once the 1-year bond matures, I'll use the proceeds to buy another 5-year bond. This way I'll be getting income every year as well. The plan is to keep buying the newest 5-year bond with the funds from the maturing bond. Since the longer the date to maturity the higher the coupon, I'm always getting the best deal I can get at the time.

Another way to mitigate risk is to buy a bond ETF which will hold a basket of different bonds so that a bond defaulting doesn't result in the devastation of the whole portfolio.

This was a quick glimpse on bonds which is an important asset class in the investing world because many people use them to help stabilize their overall portfolio since they offset the volatility of stocks. Hopefully this has been a little informative so that you can effectively use bonds as well.

-the Paperboy

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