How to Invest Your Money » Bonds

The Basics On Bonds

Even though the size of the bond market dwarfs the size of the stock market, bonds don’t get nearly the attention stocks do. Many investors don’t know squat about them. And let’s face it, bonds are boring. Stocks are much more sexy. Certain stocks have the potential to go up exponentially, even though that rarely happens. A lot of stocks have the potential for both capital appreciation and income, thanks to their dividend. Only Grandpas own bonds! They’re more boring than a rambling story about onion shortages in 1934. Why should an investor even care?

Bonds typically move inversely to stocks. If stocks are down, bonds will usually be up. During periods of stock market weakness, bonds will lessen the damage on the total portfolio. Even during periods of stock market gains, bonds will still be spinning off interest, adding to portfolio returns, albeit at a lower return than the stock component will. But first, the basics. What is a bond?

A bond is a debt instrument issued by a corporation or a government. The issuer needs money now for whatever reason, so they ask investors for the money. Since investors want to be compensated for use of their capital, the issuer agrees to pay interest, usually in six month intervals, back to investors. Such greedy investors, always looking for their interest. The bond issue will have a length of time, after which investors will want their entire investment paid back, which is called the maturity. The appeal in bonds is getting the interest payments in the meantime.

A bond trades a lot like a stock, just in a much less public market. All bonds start off trading at 100, which is known as par. If a bond is trading above par, it’s said to be trading at a premium. If the bond trades below par, it trades at a discount. The prices move, just like stock prices do. As the prices move, that affects the return on the bond. If a bond yielded 6% when it traded at par, it would stand to return more than 6% if it was trading at a discount, since the investor would get a capital gain once the bond matured and the original investment was paid back. If a bond was trading above par, the investor would get slightly less than the yield as a return, because of the slight capital loss.

Whew! Bored or lost yet? I think the real reason nobody cares about bonds is that they’re complicated.

So why does a bond move up or down in price? There are two main reasons, either company specific reasons or general economic reasons. Take General Motors for example, back in circa 2007 before they went bankrupt. Much like the share price, the price of GM’s bonds began a slow slide into the abyss, as bankruptcy became more and more likely. The bonds suffered because of the health of the company.

The reason why bonds move in a more general direction is because of interest rates, or rather the expectation of interest rates. If news comes out that is good for the economy (which would drive up interest rates) bonds generally go down in value. The opposite happens when bad financial news comes out. This is why the business news shows quotes of popular government bonds, since they serve as a proxy for the bond market as a whole.

All right. I know half of you are probably asleep by now. Let’s get to something slightly more interesting. How should an investor play the debt markets?

I don’t think someone should be investing in individual bonds. Buying bonds isn’t nearly as simple as buying stocks. Instead of charging a commission, brokerages take a spread between the price that the buyer pays and the seller gets. The smaller the order, the higher the spread. Because of that, institutional investors get a much better deal when buying debt than individual investors.

So why bother? There are all sorts of exchange traded funds out there that hold bonds. The level of risk of these ETFs ranges from the ultra conservative government bonds to risky bonds trading at large discounts, aptly named junk bonds. Investors can choose between Canadian, American or international issues, just by buying an ETF. You don’t need to take on any company specific risk either, since most of these ETFs can hold hundreds of different issues.

Most of the bond ETFs on the Toronto Stock Exchange come with an added feature, one that is mostly advantageous to Canadian investors – Canadian dollar hedging. This means that investors won’t be punished for currency fluctuations.

I’m a young investor, so I only hold two bond funds in my portfolio. The first is a fairly conservative fund filled with high quality Canadian bonds, which trades on the TSX under the symbol XBB. It yields just a bit under 4%. Over the past 5 years, the fund has traded between $28 and $30. The yield isn’t very high, but the fund is very conservative, hence the 4% yield.

The other fund I hold is on the exact opposite end of the risk spectrum. The Dryfus High Yield Strategies Fund (DHF)  invests in junk bonds, and then uses a 25% leverage position to enhance returns.  The yield as I write this is over 10%. Obviously, that 10% yield reflects the riskiness of the position. It invests in the most speculative of debt issues, and uses leverage to get a higher yield. It’s not for the faint of heart.

This is only a basic look at bonds. The bond market is complex, but investors need at least a portion of their portfolios to be in fixed income assets. Yes, it’s not the most sexy of investment topics, but it’s too important to not learn about.

Comments

  1. Ross Taylor

    Thanks for this great article Nelson – I featured it in my weekly round up in “the best of the rest”

    http://rosstaylor.org/ross/ask

  2. Jamie

    Nice article. It is a good advice for investors to buy bond funds rather then individual bonds. It’s difficult for retail investor to do that, this way you get professional fund manager to manage your money.

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