Readers often ask why and how one should buy bonds. The reason used to be to get interest at a rate above what stocks pay as dividends. That does not work anymore, for bank stocks and big telecoms, for example, pay four to five per cent. Ten-year Government of Canada bonds pay 2.5 per cent. Interest isn’t the only reason to buy bonds.
Bond interest rates remain near all time lows, but that doesn’t mean you should not buy bonds. Rather, you should buy the right bonds for the right reasons. Very low interest rates make some fundamentally conservative government bonds highly responsive to interest rate changes and potentially hot assets.
Let’s take government bond choices from the bottom. That’s Canada Savings Bonds. Their underlying interest rates are abysmal. For one year, currently you get one per cent. The most one can say is that CSBs are a way to hold cash with absolute safety. The issuer, the Bank of Canada, will not default. You can cash certain CSBs on demand, so they are like a portable savings account.
Negotiable government bonds in the U.S. and Canada pay little but have some remarkable properties. First, they are liquid and can be converted to cash through any investment dealer. They have no default risk. Bonds due in five years or less have little sensitivity to changing interest rates. But bonds due in 10 or more years up to 30 and even 50 years are highly sensitive to interest rate changes. If rates rise, existing bonds will be undesirable and will fall in price. If rates drop at 10 years, 20 or more years out to 50 years, existing bonds will be very desirable and may rise dramatically in price.
Now here is the kicker. There are fears of deflation in Europe and even in North American. In that case, prices of stocks and most corporate bonds would plummet. Because national banks like the Fed and the Bank of Canada can print money if need be to pay interest, government bonds would soar. The longest bonds would be the biggest gainers. Indeed, a stripped bond which has no interest payments and, instead, is bought at a steep discount at issue or many years before maturity, would rise in price by a number equal to the years to maturity times the interest rate decline. Thus a 20-year strip bong holder faced with a two per cent drop in long interest rates would gain 20 x two per cent, or 40 per cent. Of course, if rates rise by two per cent, the strip would lose 40 per cent.
Provincial bonds offer a little more interest than federal bonds, usually about half a per cent per per year. Provinces and U.S. sub-federal issuers such as highway authorities and toll roads and bridges cannot print money, but most have the power to tax. In a severe deflation, these bonds could suffer.
Corporate bonds are rated AAA for best of breed to B, which means okay for now but not certain in future and vulnerable to business cycles, to C, which is dubious, to D, which means in default and not paying interest or repaying principal. Corporate bonds are easy to buy when issued and, for BBB+ or better for five years or less, default is not a serious issue. But a few weeks after issue and for issues of $500 million or less in Canada and $5 million in the U.S., resale can be tough. And, if you want U.S. bonds, you’ll have to contend with exchange rates.
The virtue of all actual bonds is that they mature at a known date at an absolutely fixed value. In the event of deflation, the promise of known cash interest payments, usually every six months, and absolutely certain return of principal in a known amount makes them baseline investments.
Trading actual bonds is complex and can be costly. If you want bonds a few weeks after issue and well before maturity, you will pay hefty fees to the dealer. But you can buy numerous variations on bond portfolios as exchange traded funds from iShares, BMO ETFs, First Asset and many other issuers.
Bond mutual funds come in numerous flavours. They can hold Canadian bonds, U.S. bonds, global bonds, mixes, short bonds, long bonds, corporates, inflation-linked bonds and combinations of all of those. Managers can be nimble and try to outsmart the bond market, but the great majority of bond mutual funds will underperform their indices for one reason — fees that, for most investors, eat up most of the interest paid.
Finally, there are old-fashioned guaranteed investment certificates. They are retail products, pay less than government and corporate bonds for five years and less, but they are insured by the Canada Deposit Insurance Corporation or various credit unions and caisses populaires and — this is the best part — they will not lose value if interest rates rise. You are locked in for defined period and you can cash out only with penalties.