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A How-To Bond Investment Guide For Beginners

Why buy bonds and, if you want to, how do you do it? We re not talking about Canada Savings Bonds, which pay approximately zilch, but about negotiable bonds that can pay enough to put dinner on the table and, for adept investors, a good deal more.

Think that s impossible with two-year Government of Canada bonds that pay about 2.2 per cent per year to maturity or 30 year bonds that pay about three per cent to maturity? No, it is quite possible. Here is how it works.

Bond prices move opposite to their yields. Yield is the return divided by the price of the bond. When yields rise, bond prices fall and vice versa. Here s an example. If a $1,000 bond came out with a five per cent yield, $50 per year, and interest rates suddenly rise to 10 per cent per year, then the $50 yield could be gotten from a $500 bond. It works in reverse too, so that if a $1,000 bond with a 10 per cent yield now faces a market in which new bonds pay just five per cent or $50 per year, then the bond price will soar to $2,000 because $50 is five per cent of that amount.

In the present market, racked with fear of Greek bond defaults, central banks have been pushing down interest rates. Short term rates for bond terms of a few days to a year are just fractions of one per cent. But rates at two years and longer could go down further as a result of even more central bank adjustments. So if you do buy a two year bond or a five or a 10 or a 20, you could find yourself with a capital gain. Indeed, in this market, most of the gain on bonds that are bought and sold by traders (and not just put under the mattress like Canada Savings Bonds) are purchased for potential capital appreciation.

There are many ways to buy bonds. You can buy the bond itself from a stock broker. Those brokers that have licenses to sell stocks and bonds are also called full service brokers, discount brokers or online brokers. These days, there are no physical bonds. You get a credit on your account when you buy after cash on deposit in the account is debited.

When you sell the bond, you get cash on deposit and the bond line shrinks in the event of a partial sale (selling $5,000 out of a $10,000 bond position) or disappears if you sell all of your bonds.

You can also buy bonds in bond mutual funds. The good part is that many bond managers know their stuff and can make money even when, as now, interest rates are very low. The bad part is that bond fund fees, which average a suffocating 1.55 per cent of net asset value, can suck virtually every penny of yield out of your returns. Not all bond funds have such high fees. Shop for bond funds online and you will find some fine ones that have fees as low as 0.6 per cent.

If you want to get really low fees, you can buy your bonds as exchange traded funds. The fees are lower, as little as a fifth of one per cent of net asset value. If you buy your bond ETFs via a discount broker, the trading costs may be just a few dollars.

Bond ETFs come in many flavours including Canada government bonds, U.S. Treasury bonds short (one to five years), medium term (out to 10 years) and long (out to 30 years).

There are U.S., and Canadian corporate bond funds too. Because corporate bonds can default, the return is a little higher. But bond ETFs tend to pick investment grade bonds with very little default risk. Diversification into dozens of issues dilutes the default risk so that it is not serious.

You can buy bonds in an incredible variety. There are Canadian government and corporate bonds, U.S. government and corporates, inflation-protected bonds that compensate for inflation (unlike conventional bonds that suffer from it), commodity linked bonds that pay more when the price of copper or gold or whatever rises, bonds from most countries in the world either individually by country or in various packages of countries, junk bonds that are much the same as stocks, funds that speculate in defaulted bonds, and bonds and funds of bonds that convert to stocks. You can also buy bond futures, bond indexes and futures on bond indexes. However, for most investors, it is best to start simple in domestic government and high grade corporate bonds.

Bond funds offer expert management in the case of mutual funds with active managers and diversification with no management in the case of ETFs. But there is a downside to all funds. In the event of a major liquidity crisis when everybody wants cash to pay off loans or just to stuff into safe deposit boxes, bond funds both managed and ETFs may have to sell both the good stuff and their losers, even losers that could turn around and be profitable. That forced selling can leave the investor with unexpected losses and, if the positions are in taxable rather than RRSP or TFSA accounts, there can be capital gains or losses. That amounts to unplanned outcomes. So be aware that when you get into a pooled investment with other people, the will of the masses may govern.

If you want to go it alone, which is fine if you just want Government of Canada or provincial bonds that have no default risk to speak of and no risks with foreign currency exposure, then you have to deal with a bond dealer. Bonds are not like stocks, however, for the dealers act as principals. They sell bonds out of their own inventories and therefore want to make as much as they can. When they buy, they like to pay as little as possible. That means that retail spreads, the difference between what you pay or get and what the dealer pays or gets can cost you.. Big pension funds with muscle get smaller spreads, of course. Stocks are traded on commission and so the spread is irrelevant.

If you do buy bonds directly from a broker, then you pay for the bond plus accrued interest. So if the bond pays 12 per cent per year and the interest payment date is Oct. 31, then buying the bond on Dec. 1 means you have to pay the price plus a month s interest, which is one per cent in this example. This has to go into your pricing estimates.

If you have an established account with a broker and want to get bonds at issue without paying a hefty markup, you can indicate interest and sometimes get the bonds at what is called a noncompetitive bid, that is, you will pay what large institutions pay. You have to set this up in advance and work with your sales person to make this happen.

The procedure is to indicate an interest in buying government bonds when issued. If you are ready to buy when the bonds are issued, you will get the day s best price or perhaps close to it. Prices may drop the next day or next week, or rise, but you will have gotten at least the day s best deal.

Buying corporate bonds is challenging. You need to read the offering documents, understand when and if the bond may be

called in by the issuer prior to maturity, understand the credit standing of the issuer, examine how much money the issuing company has to service the bonds and pay interest due, and get a sense of the attitude of the investing community toward the bonds. If you buy obscure bonds issued in small amounts under $100 million or so you may have a solid investment but be unable to sell before maturity. Issue size influences the liquidity of the market for the bond.

Finally, and this is a critical point, understand that much of the bond market is invisible. Unlike stocks, which have their prices published every second of every trading day, most bonds are not traded, are therefore not price, and their prices, even when known by the insurance companies and pension funds that own them and trade them, may not be easy to find. Of course, if you own a bond exchange traded fund, its price will be published just like that of any stock. It will be listed on the Toronto Stock Exchange or on other exchanges around the world. If you buy a bond mutual fund, your manager will take care of pricing and trades.

This may seem complex because it is. But it is also rewarding. In this tough market, Canadian fixed income mutual funds returned 3.8 per cent for the 12 months ended August 31. Some bonds funds, such as those holding inflation-protected Real Return Bonds, returned 10.5 per cent to holders in that period. Yet global bond funds paid just 1.3 per cent, largely because the Canadian dollar rose and took away some of their gains.

In the end, bond investing is worth doing. It can add security to a stock portfolio, income especially in RRSPs where there is no tax on returns until the money is paid out, and provides an asset that, in general, tends to rise when stocks fall. Bonds are worth having, but picking them remains part science, part art. Study the market first, then put a toe into the waters.

As you become more familiar, you can add to your bond portfolio. It may not be as exciting as stock investing, but bond investing can provide the stability that stocks lack.

AndrewAllentuckistheauthorofBondsfor Canadians,publishedin2006,andWhenCan IRetire?PlanningYourFinancialLifeAfter Work,publishedearlierthisyear.

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Unlike stocks, much of the bond market is invisible

About the author

Columnist

Andrew Allentuck’s book, “Cherished Fortune: Build Your Portfolio Like Your Own Business,” written with co-author Benoit Poliquin, was recently published by Dundurn Press.

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