Bonds provide stability not offered by stock market

Every day, some $5 billion of stocks trade hands in Canada. That's a lot of money.

But what trades about 10 times as much dollar volume every day?

The Canadian bond market is many times the size of the stock market, and its trading trends can help determine mortgage rates, the level of the Canadian dollar and the rates of return on many of your mutual funds. Yet the daily trading results attract much less attention.

As the name suggests, a bond is a promise. It represents a commitment from a user of capital (a borrower) to repay an investor (a lender or provider of capital) a fixed amount of interest for a fixed term, and then to repay the principal at an agreed later date.

Bonds are issued by governments, municipalities and corporations. You are likely familiar with Canada Savings Bonds and Manitoba Builder Bonds. These savings bonds do not generally trade every day in what we call the "bond market." They are typically held to maturity.

Builder Bonds are available now until June 5th. The rate on the five-year floating bond is 1.75 per cent for the first year. The three-year fixed bonds pay 1.85 per cent, and the five-year pays two per cent. The following comments do not apply to them.

Corporate bonds sometimes have variations or "sweeteners," such as the right to convert the bond to the stock of the same issuer at a predetermined price, or the ability to redeem early or to extend the term. Some bonds have been "stripped," with the principal portion separated from the interest or coupon portion. These do not pay regular interest, but simply mature in the future at a higher value. The growth, however, is taxed as interest income.

The "coupon" is the amount of interest agreed to be paid, calculated on an assumed face amount, typically $100 when issued. If the coupon rate on a bond is five per cent, then $5 interest will be paid yearly on each $100 face amount.

Once bonds have been issued, they then trade on the secondary bond market -- an electronic web between bond traders, who ask a certain price for different bonds they own and bid for bonds they want to buy.

So what if the bond market rallies, prices rise, and that $100 bond is now trading at $105?

This is where it gets interesting. When the news report says "the bond market is up today" it means prices are up. People who own bonds made money that day.

However, people who want to buy bonds the next day have to pay a higher price. Since the interest paid on those bonds is fixed, a higher price actually means a lower percentage interest rate.

"Yield" is the interest rate to be earned on a bond at its current price. When bond prices go up, yields automatically go down.

If that five-per-cent bond is now trading at $105, then the actual yield is now the $5 coupon, divided by price ($105) times 100 4.76 per cent.

Also factoring into your investment decision is the fact the bond will mature at $100 in the future, which means a five-per-cent capital loss from your $105 purchase price. In this case, the actual yield-to-maturity of a 10-year bond paying $5-a-year interest, purchased at $105, is about 4.37 per cent, if all interest payments are also reinvested at five per cent.

If you can buy a lower coupon bond at a discount, and you receive less interest and a guaranteed capital gain, that's a better strategy.

Bond prices are much more stable than stock prices, the interest rate is guaranteed and bonds rank above preferred shares or common stock if the issuing company is liquidated. Bond prices tend to go up when there is bad news for the economy, because that bad news typically means slowing economic activity, a future drop in inflation and no pressure on interest rates to rise.

Therefore, bonds will often rise when stocks fall, making them a useful stabilizer in a portfolio. However, they do have short-term risk, and can fall significantly in price if interest rates rise suddenly, or if the bond market suddenly sees inflation and higher interest rates on the horizon.

An excellent strategy is to set up a "ladder" of bonds, with bonds maturing each year. If you hold them to the guaranteed maturity value, then you can ignore short-term price fluctuations.

For detailed study, purchase Andrew Allentuck's 2007 book Bonds for Canadians, or In Your Best Interest, by W.H. "Hank" Cunningham.

David Christianson is a fee-for-service financial planner with Wellington West Total Wealth Management Inc., a portfolio manager (restricted).

dchristianson@wellwest.ca

Republished from the Winnipeg Free Press print edition May 25, 2012 B8