Bond, Fixed Income Bond
Peter Katevatis - Jul 09, 2014
Interest rates are low. Not quite the most ground breaking statement of 2014, but that is the environment we are in. Looking backwards, interest rates have been low for 5 years and falling since the late 90s when Pierce Brosnan became James Bond.
Interest rates are low. Not quite the most ground breaking statement of 2014, but that is the environment we are in. Looking backwards, interest rates have been low for 5 years and falling since the late 90s when Pierce Brosnan became James Bond. Even though rates are low, a properly constructed investment portfolio should have a portion of fixed income. The specific allotment you should make to fixed income will be determined by your risk tolerance, time horizon, and specific goals. Take the time to determine your needs and specific allocation.
Whatever your fixed income or bond portion is, here is a breakdown of the different types of investments that would constitute this part of your portfolio.
Government Bonds – These are considered the safest bonds as the “issuer” is the federal or provincial governments and are considered the most stable. Safest also means these bonds have the lowest return.
Corporate Bonds – These are bonds that are secured by the assets of the corporation. There is a broad range of risk in this type from a safe (AA rated) Bank of Montreal to a riskier (BB rated) Air Canada.
Strip Bonds – These are the sexiest bonds in the fixed income space and have a coupon of 0%. The entire yield is generated by the appreciation of the principal to $100. These always trade at a discount.
Convertible Bonds – With the wind in their hair, these are corporate bonds that have the option to convert into common shares at a set strike price. They usually have a lower yield but you can participate in a company’s upside if the common shares move above the strike price.
Preferred Shares – Also known as prefs, these hybrid shares trade like bonds. However, unlike a bond, they do not mature so getting your principal back can be problematic especially in a rising interest rate environment.
All bonds have similar attributes, here are the terms that are used in the bond world.
- Issuer – this is the name of the government or company who issues the bonds
- Principal – this is the face value of the bond. when it matures you get this back
- Coupon – this is the annual rate of the payment, it can be paid quarterly or bi-annually
- Maturity – this is the date the bond matures and your principal is returned to you
- Price – this is the current price the bond trades at, it matures at $100
- Yield – similar to coupon but this is the return the investor receives if they bought the bond today
These terms are extremely important to understand. Many bonds were issued at times when interest rates were higher. These bonds have a tendency to pay a larger coupon. Since the current yields are low, these bonds will trade at a higher price (premium) so that their current yield reflects the interest rates of today.
For example, a Government of Canada bond, which matures in exactly one year from now may have a 3.0% coupon. Current 1 year Government of Canada bonds return approximately 1%. Therefore this bond will trade at a 2% premium ($102). A buyer today would receive a 3% coupon then lose 2% on maturity when their $100 is returned to them. The net return would be the current yield of 1%.
I consider cash a separate asset class for investing purposes. Current cash savings rates are 1.25-1.5% using High Interest Savings Accounts. Historically I have used Manulife Bank but the top rate is from Equitable Bank at 1.5% which is oddly higher than the dividend payable on their shares.
There is often a debate about who the best James Bond actor has been. I find the “Who is the best villain” conversation more intriguing. I personally prefer Ernst Stavro Blofeld (Donald Pleasence version) although a close second is Christopher Walken’s Max Zorin. Do you have a favourite Bond villain?