Ahh … the sexy Bond. It’s the one thing investors can’t get enough of right now. Is it the allure of safe returns with a hint of excitement? Or maybe it’s the payback that you’re looking for. Nevertheless, bonds have become very popular in our recessive times, but I’m writing here to lift the veil of mystery surrounding bonds.
I’ve written much about saving and opening up investment accounts, but for most people the hardest part is coming up with what to do with your money? Most financial institutions will lead you down the path of investing your money in a GICs (Guaranteed Investment Certificate). It’s the safest investment someone can make because your capital is guaranteed and you are never going to lose it. The one downside of a zero risk investment is that you get nothing in return. You are essentially giving the bank money for free and letting them lend out that money to people looking for loans at a much higher interest rate than you are getting paid. Aren’t you feeling used and abused right about now? Do you think Mr. Bond would stand for this?
So let’s look at this thing called a bond. A bond certificate can be thought of as an “I owe you”. Each bond has something called a maturity date. It’s the date at which the value of the bond must be repaid. This time range can be as little as a few months to many, many years. A bond will also have something called a coupon rate. This is essentially the interest amount that the bondholder will receive annually based on the face value of the bond. A bond will always have a face value, this could be $50, $100, $1000, etc. The holder of this bond will always receive their coupon rate interest. So if you hold a $100 bond at 5% interest, then you’ll receive $5 every year.
This seems really simple. It’s almost like a GIC, so what’s the difference? Well for starters, a bond is traded on the stock market, very much like stocks of a company. Even though a bond has a face value, it doesn’t actually trade at that price. What this means is that a bond can have a face value of $100 giving 5% interest, but actually sell on the market for $150. What does this mean? It means that if you buy that bond, the actual interest you will be receiving will not be 5%. You still receive $5 annually because you own the bond, but since you bought it at $150, you are essentially getting 3.33%. Not only is this the case, but if you hold that bond until the maturity date, you don’t get back $150, but only $100. Not only do you get less interest, you also lose $50 by holding it to the very end. Uh oh, wait a minute, I thought bonds were safe? Bonds are safe, but even 007 gets into trouble every now and then, especially if you don’t know what you are doing.
So how do you circumvent these risks? For starters, as I mentioned above, bonds have different maturity dates. As the date of maturity gets closer, the bond price tends to veer towards the face value of the bond. When buying bonds individually, it is very important to pay attention to these details. These details I’ll cover in a later entry, but for starters, buying a bond mutual fund or ETF will take much of that risk away as fund managers will deal with the situation of maturity rates and coupon rates. A lot of the risks that you would take buying bonds yourself would be managed by professional fund managers. For a beginner that is not so keen on doing financial analysis on bonds, this is a perfect way to go about getting exposure to bonds. Besides, we all have better things to do on our Friday evenings and weekends than sitting around reading about bonds. Don’t we?
Now that we know that bonds are traded just like stocks of a company, how are the risks lower? Won’t the bonds fall just like stocks do when the market crashes? Quite the contrary. Bonds behave almost exactly opposite to stocks. When times are bad, most people flock to bonds because they represent a safe return on their investments. When stocks are doing well, bonds tend to drop in price and thus the yield from the interest becomes higher.
There are many types of bonds, ones that most people are familiar with are government bonds. The Canadian Premium Bond is essentially an “I owe you” that the Canadian government issues to borrow money to finance all those perks that Canadians enjoy. Money doesn’t get printed on Parliament Hill, despite popular belief. Governments that have good credit ratings, like Canada, tend to enjoy lower interest rates, because people on the open market are more willing to pay a higher price than the face value of the bond from a country that is less likely to default. With Greece, investors were so spooked that you could buy a bond for LESS than the face value of the bond. So when you buy a government bond, you are essentially saying, well do I think my country will go bankrupt? Remember, if that happened, not only would your money be gone, but the rest of your life would be hell too. Just look at Greece.
Similarly, big corporations also issue bonds as well. They also use bonds to raise money to fund their operations. Companies with outstanding credit ratings (double A or more), generally tend to have bonds that pay very little interest because the likelihood of that company not paying back that “I owe you” is small. So what makes the bond different than a stock? A bond makes you a debtor to the company. It means that company owes you money. If the company does well, you don’t get to share in the success of the company. To be honest, because you’re a debtor, you’re actually detrimental to that company because your interest payments are an expense to them. What do you think about yourself now, huh? Since you are a debtor, if by any chance a company goes bankrupt, they must pay you back first before giving money back to the shareholder. Take for instance Nortel. It went bankrupt and is still slowly liquidating it’s assets, patents, technology, etc… Once that sale is made, any money goes to a bondholder first before a shareholder. Generally when a company goes bankrupt, there is always an intrinsic base value that the company is worth. As a bondholder, you’re very likely to get back at least a portion of your capital.
The average return on bonds has historically been below 5%. This is certainly not as high as returns that one would get from stocks or even real estate, but nonetheless, bonds should be in the portfolio of every investor. It protects the investor during turbulent economic times, while at the same time giving a steady income. Bonds should be one of the building blocks to a balanced and diversified financial portfolio. Without bonds, you run the risk of putting yourself in greater financial danger. Not all of us have the tools like 007 to get us out of trouble.