A Primer on Bonds – II (Investing in Bonds)
This is a column by regular contributor Clark
If you had read Part 1 of the primer, you would have learned about the basics of bonds and their different types. Bonds offer a reasonable rate of return, though lesser than stocks, and provide protection against volatility. So, is an investor, willing to settle for lesser returns in exchange for better sleep, safe with bonds? Yes, if we turn a blind eye to interest rate risk!
Interest rate risk
The Bank of Canada sets interest rates and other banks determine their prime rates based on it. Interest rate risk refers to the change in value of an interest-earning instrument like bonds due to variability in interest rates. Typically, as interest rates rise, bond prices fall and vice versa. An example may help to understand better.
Say, a 3-year bond valued at $100 pays 3% interest in the current environment. If interest rates rise by 1% after a year, 2-year bonds would pay 4% whereas our bond would still pay 3%. Why would an investor buy our bond when he can get a higher rate? The only way to make our bond worthwhile would be to lower the value (price) of the bond, so that the difference in price will offset the higher interest rate existing at that time. In our example, the 2-year bond would yield $4 per year in interest for a total of $8 over 2 years + the principal of $100 at maturity. If the price of our 3-year bond is lowered to $98.10, then the investor will earn $6 in total interest over 2 years + $1.90 in capital gains (since he will receive $100 at maturity), which would equal the return of the 2-year bond.
The variation in bond value occurs because the investor receives a fixed return in relation to the market. If the market (interest) rate goes down, then the bondholder owns a security that is worth more, since the new bonds would offer a lower rate of return and vice versa. The duration of the bond is a key factor in determining risk. While all bonds are affected, longer term bonds take a more severe hit because of their duration to maturity and the possibility of facing more fluctuations. It is true that the variation could go both ways but I’ll point to more knowledgeable commentaries for reference.
Suitability for portfolios
1) Retirement portfolios are good candidates where the investor would prefer a fixed income while safeguarding the principal. The percentage of bonds may vary but it is critical to have a few.
2) Short-term needs. Saving for goals that would require the money in 3 – 5 years through the stock market would not be prudent due to market volatility. Bonds are also likely to face interest rate risk or defaults but buying a short-term bond ETF would ensure a healthier return than savings accounts and maybe, GICs too (will depend on the term that the money is going to be locked in). With depressed rates offered by savings accounts, this strategy may seem enticing but may not work for many people as there is the chance of principal loss, albeit less than equities. The bond ETF could go down in value due to interest rate fluctuations and bond return may also drop. As always, due diligence is required!
How to buy bonds?
Bonds can be bought individually, as index funds or ETFs. Typically, individual bond issues require a minimum investment of $5000 or more. Buying a bond index fund or ETF offers diversification by holding a selection of investment-grade government and corporate bonds. In addition, a bond fund or ETF is liquid and can be redeemed at any time (commissions have to be accounted for!), whereas individual issues may not be as liquid and have high bid-ask spreads.
Readers, do you hold individual, index fund or ETF bonds? If you’ve got tips about investing in bonds, please do share in the comments.
About the Author: Clark is a twenty-something Saskatchewan resident employed in the manufacturing sector. He repaid around $20,000 in student loans and has been working to build his investment portfolio as a DIY investor (not trader) while nurturing plans to retire early. He loves reading (and using the lessons learned) about personal finance, technology and minimalism.