Winnipeg Free Press - PRINT EDITION

Investing in bonds -- not as simple as you think

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So, let's say I am a conservative investor with a primary goal of capital preservation. As a result, I invested 70 per cent of my RRSP into a number of government bonds because I did not want to take any risks.

So, imagine my surprise when I looked at my June 30 investment statement and found my portfolio was down four per cent on the quarter. How the heck did my government bonds with guaranteed maturities decline so much?

A full explanation is coming, but first be assured if you own those bonds directly and hold them to their guaranteed maturity date, you will receive the full value and the yield-to-maturity you were promised.

However, if you own those bonds indirectly, such as through a mutual fund or ETF, you have no such individual guarantee on the maturity value. Instead, you own units of a pool that owns a group of such bonds. In this case, you are dependent on the bond prices recovering, or the manager holding to maturity. Bond funds, balanced funds and bond ETFs suffered similar declines in May and June.

OK, let's go back to bond basics. Bonds trade every second on a market far larger than the stock market, in the trillions of dollars around the world. Price is set by supply and demand, but is heavily dependent on the outlook for interest rates. If bond prices go down, interest rates -- the yield paid on those bonds -- go up.

For example, if a 10-year bond is issued at $1,000 and has an annual coupon of four per cent, it will pay the holder $40 cash each year. If, one year from now, rates on new nine-year bonds are five per cent, no one will pay you $1,000 for your bond. They would buy a new one instead, or offer you a lower price.

Your bond, which is now a nine-year commitment from the issuer, would likely attract a price of about $930. This is the price at which the purchaser (or you the holder) will receive roughly five per cent over the next nine years, and the mechanism that really sets interest rates in the marketplace.

If rates rise, longer-term bonds will fall more than short-term bonds, all things being equal. (They will also rise more if rates decline.) Lower-coupon bonds, with a low annual cash payment, will fluctuate more than high-coupon bonds, which pay more cash each year.

So, was your bond a safe investment? Yes, as you are still guaranteed the original four per cent promise if you hold to maturity. With a government bond, there is virtually no credit risk, default risk or option risk. However, there is interest rate risk, as we have seen, and there is inflation risk. If the rate of inflation exceeds your after-tax return on the bond, you will lose purchasing power over time.

Corporate bonds, especially those of companies with low credit ratings, have all five of the risks mentioned, but they pay higher interest rates. Option risk exists in the case of callable bonds, where a company can call your bond and pay you back if interest rates go down. This can also be called pre-payment risk.

Convertible bonds provide the holder with a right to convert to the company's stock at a predetermined price. If the stock price goes above this conversion price, then the bond will start to trade more like a stock.

By the way, professional bond traders would not consider your bond a 10-year bond, even on the issue date. They use formulas to determine an adjusted term, based on the cash flows to be paid to you during the term. They would calculate the duration on your bond to be less than 10 years, because much of your return ($40 on your $1,000 investment) will be paid before maturity. Only strip bonds have the same term and duration because there is no coupon payment until maturity.

Bond managers also calculate Macaulay duration, modified duration and convexity to know the expected volatility of their portfolios and to compare bonds with different terms and coupons. They will shorten their portfolio duration if they sense interest rates are going to rise, to decrease price declines, and lengthen duration if they think rates will fall, to maximize price gains.

Do not let any of this scare you, as fixed income is a critical part of every diversified portfolio. My purpose is to help you ask more questions before you invest and examine all the risks, especially when we know interest rates will have to rise sometime over the next decade (and likely much sooner).

 

David Christianson, BA, CFP, R.F.P., TEP, is a financial planner and adviser with Christianson Wealth Advisors, a vice-president with National Bank Financial Wealth Management, and author of the book Managing the Bull, A No-Nonsense Guide to Personal Finance.

Republished from the Winnipeg Free Press print edition November 15, 2013 B17

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