Stocks flourish on good company news, a bit of inflation to push up prices, moderate growth in corporate earnings, and the optimism of investors looking forward to rising incomes and climbing profits.
Bonds, on the other hand, are for pessimists. As economic growth slows, the demand for loans declines. Inflation subsides. In this atmosphere, bonds thrive. Interest rates tend to fall, and existing bonds which promise fixed income at specific dates attract attention from investors seeking security and shelter instead of risk and market profits.
The problem with this model is that it works differently at different times. Today, for example, bond interest rates are in the low single digits. Investors need to park their money for decades just to get a few measly per cent interest. Should interest rates rise, prices of existing bonds with low payments, called coupons in the investment biz, will tumble in price. Even a one per cent pickup in inflation could shave as much as 30 per cent off the price of a strip bond, called a zero in the U.S. — it’s a bond that defers paying all interest until maturity.
The bond market has become a place where investors trade risk in how their companies’ stock might do for the assurance that high quality bonds, called investment grade bonds, will inevitably come through with interest payments and then return their capital. It is a most peculiar bet these days.
Here is an inside tip: The less risky a bond, the shorter its story. If you buy a Government of Canada bond or a U.S. Treasury bond, there is no story. You put up your money at your investment dealer, your account is credited with the bond you’ve bought and nothing more need be said. The odds that the government issuer will default are trivial. End of story.
A provincial bond or a municipal bond has a slightly higher interest rate. In Canada, if a federal bond pays 1.5 per cent for 10 years, a Government of Ontario bond will pay two per cent, give or take. The bond shopper should be concerned with the health of the Ontario economy, the history of defaults by the Province of Ontario (never), and the market’s taste for Ontario bonds (always strong).
Move to a high grade corporate bonds, such as a 10-year Bell Canada Inc. issue, and you can get three per cent as I write this column. Bell has a longer story. It’s an active phone company, its traditional products, wireline phones and related products, are dying out. It has entertainment assets and some information media — always fragile. But for 10 years, it’s a good bet. Still, you’d want to go to a credit rating site like DBRS (formerly called the Dominion Bond Rating Service), discuss the bond with an investment dealer or check it out in the database of an online brokerage before buying. Lower quality bonds have longer tales about recovery of business, clever management, etc.
The paradox of the bond investment business is that, given the very low interest rate coverage that all investment grade bonds offer these days, the investor’s greatest risk is inflation and higher interest rates. You can mitigate that risk by reinvesting every single coupon — most pay every six months — at the higher rates of interest should they prevail. You can do this if you have millions of dollars in bonds, but the theory does not work with just a few thousand, for bonds come in $1,000 issues or “pieces” as they say in the financial business.
Rather than do all the research to buy a single bond, you can buy a bond exchange traded fund. There are many. The big exchange traded fund managers such as iShares have many types of bonds. You can buy the broad Canadian bond market, U.S. Treasuries with short or long maturities, or bonds laddered from one to five or one to 10 years so that if rates rise, the fund will roll maturing bonds into new issues with higher rates. There are bonds that link their payment rates not to interest rates, but to inflation rates. Much like buying a custom made suit, you can get whatever fits.
The four secrets
Here are the secrets of buying bonds without getting beaten up by rising interest rates.
1: Buy bonds as a complement to stocks.
If you have just investment grade bonds, you have a lot of naked exposure to interest rate changes. These days, there are negative rates on 10 year government bonds in Japan, Switzerland, Germany and some Nordic countries from time to time. Why people buy bonds guaranteed to be worth less at maturity than at time of issue is a mystery wrapped in an enigma, as Churchill said of Russia on the eve of World War II. Regardless of motives, they can be explained in the complexity of global bond markets: if interest rates fall even further, existing negative pay bonds will be worth more than bonds that pay even less. But you, an off-farm investor, do not want them. The great rule of bond investing is this: stick to plain vanilla bonds with positive interest, few stories, issued by governments you trust or strong companies.
2: Do not chase bond yield.
You could buy a Sherritt International bond with a 7.5 per cent coupon due Sept. 24, 2019 at a price discount so steep that $480 upfront buys you the $1,000 face value. The bond at this price offers a 35 per cent yield to maturity. This is investing for the brave. The market worries about Sherritt, which is a mineral miner with a lot of money tied up in the developing world. The rule: if you buy high yield bonds, or junk as it is called, be prepared for a side order of agony with your profits. If you have a taste for junk, buy a junk bond fund which offers diversification and expert management, and don’t buy too much. In defense of junk, it always ranks ahead of stocks in safety, for each issuer has to pay interest or be put into bankruptcy. Junk bonds tend to do well when economies thrive and interest rates rise.
3. To eliminate all risk of loss, buy bonds for a purpose with a date.
For example, buy bonds that mature the year your child starts university. You may pay more than issue price these days, for example, $1,490 for a $1,000 Government of Canada issue due June 1, 2037. You would lose $490 on the price if you hold to maturity, but you are compensated by the 5.0 per cent annual interest on this bond, which is a few percentage points higher than what new 21-year federal bonds would pay. You pay more, you get more. The capital loss is a problem for your accountant.
4: Migrate a stock portfolio to bonds slowly.
The common wisdom is that as you get older, there is less time to recover from stock market crashes. Bonds act as cushions, so you can go from 50 per cent stock/50 per cent bonds at age 50 to 30 per cent stocks and 70 per cent bonds at age 70. You give up a lot of growth in the process, for stocks always beat bonds over periods of decades, but you gain security.
We are in the fourth decade of the longest bond bull market in history. This one started in 1983 when interest rates paid on term deposits were in the high teens. Bonds have been among the most profitable investments in this period, but it cannot last. Thus bonds do provide security with their fixed and perfectly known future prices at maturity. But don’t over pay for that guarantee. Life is risk.