Shaken, not stirred
Taking the mystery out of bonds.
Bonds are a fixed income instrument that typically form part of a balanced portfolio. But what exactly is a bond, and what difference can it make to achieving your financial goals? Consider this article an introduction to what you’ve always wanted to know about this important investment option.
History lesson
The concept of a bond can be traced back thousands of years to what is now Iraq. There is historical evidence of purchase agreements that were devised to guarantee the principal payment in grain and assured reimbursement even if the borrower could not meet that payment.[1] Today, bonds are commonly used as a means for governments and businesses to fund big projects such as building new roads and bridges, or investing in major technology upgrades.
What exactly is a bond?
When an investor buys a bond, they are agreeing to loan their money to the issuer (a company, government or investment trust) for a defined period of time at a specified rate of interest. The issuer makes interest payments, called coupon payments, to the investor at regular intervals for the duration of the loan, and pays back the principal at the end of the term.
The terms fixed income and bonds are often used interchangeably, but it’s important to note that bonds are just a small subset of the fixed income landscape. The fixed income asset class also includes bank loans, floating-rate loans and mortgages – any financial instrument where there is a lender, a borrower, principal (a loan) and regular payments (interest).
When a government or company needs to raise money for its operations, it will issue a bond for a period of usually two, five, 10 or 30 years – or even 100 years.[2] Along with the length of time it will hold the loan, the borrower also decides what rate of interest to pay on the loan. This interest rate must be attractive enough for prospective lenders (consumers/investors) to purchase the bond as an investment. The interest rate can be thought of as the risk-free rate plus what’s known as the risk premium. The risk premium is the amount the investor will be compensated for taking on the risk of default on the loan. Once the principal has been decided and the interest rate set, the borrower issues the bond.
A bond is usually issued in increments of $1,000, and individual lenders will buy a certain amount of the issue. The lenders then receive regular interest payments with the understanding that they will also receive their initial investment at the end of the loan period (the two, five, 10 or more years for which the bond was originally issued).
Source: https://napkinfinance.com
Attractive bond features
Bonds typically feature a maturity date and an interest rate, carry some level of risk and may have more or less liquidity in the secondary market.
Maturity date refers to the date when the principal of the loan will be repaid.
Interest rate on a bond is set at the time of purchase and offers investors an incentive to loan out their money. Investors may earn a higher interest rate on longer-term bond agreements or for accepting a higher level of risk.
Risk relates to the probability that the borrower will not make all interest payments and pay back the principal at the end of the term. An issuer’s credit rating is one measure of this probability. Generally, government bonds may be considered low-risk and have lower interest rates based on a higher credit rating. Bonds issued by companies that have a short history or a spotty repayment record may be classed as “junk” or “high yield,” meaning they have a lower credit rating. High-yield bonds offer the highest rates of interest, but lenders must be prepared for the possibility of a default on the loan.
If a company were to go bankrupt, bondholders may be out of luck when it comes to recovering the money they invested. Bonds are higher on the debt structure of a corporation though, so in the event of a company default, bondholders may receive some percentage of their investment. Holders of equity in a company are very likely to receive nothing in a bankruptcy.
Source: www.pcecompanies.com/resources/understanding-different-layers-of-debt
Liquidity refers to the ease of selling the issue in the secondary market. If the lender needs to sell a bond before the maturity date, they may receive less than they might if they held the bond to maturity. This is because the lender needs to find a buyer, who may not be willing to pay the lender the full value of the bond and its remaining interest payments (known as the bond’s par value). If the lender receives less, the bond is trading at a discount to par. Conversely, if an issue’s terms are attractive in the current market, it may trade at a premium to par.
This is where a managed fund solution comes in. Portfolio managers work around the clock trying to uncover opportunities to buy bonds on the secondary market at discounted prices, or to sell bonds at a premium. Identifying and taking advantage of liquidity opportunities in the bond market is a highly complex skill that is best left to professionals.
Source: https://napkinfinance.com
Bond grades
The creditworthiness of the borrower is one of the most significant factors that affect the interest rate for a bond. This is why various rating systems are used to determine the likelihood that a bond will be repaid. Most bonds are rated from D to AAA. D would be in default, meaning the borrower has failed to make an interest payment or can’t repay the principal. Debt rated AAA is usually issued by some of the world’s most prosperous countries, including Canada, and a select few companies that have achieved a AAA rating.[3]
Many bond funds will hold an array of bonds across the credit spectrum with a goal of achieving a specific average credit rating for the fund. This way they can offset lower-grade, higher-yielding debt with high-quality government issues. Speak to your advisor about the different bond funds available and the strategies they employ.
Source: https://napkinfinance.com
How do bonds fit in a portfolio?
Bonds occupy the fixed income portion of an investor portfolio. Traditionally, an investor would allocate 60 per cent of the portfolio’s assets in equity (stocks) and 40 per cent in fixed income (bonds). As the investor approaches retirement, the fixed income allocation may increase as this asset class tends to be less volatile than stocks when markets decline, while continuing to provide some income from interest payments.
In 2022, bonds as well as equities posted negative returns. This was a rare year in which two asset classes that tend to move in opposite directions were positively correlated. As we move on into 2023 and inflationary pressures start to abate, the negative correlation should return. History has shown that during recessionary times, fixed income tends to outperform equities.
Source: https://napkinfinance.com
Great! Where can I buy bonds?
An effective way to allocate a portion of your portfolio to bonds is to speak with your advisor about a mutual fund or exchange-traded fund (ETF) that invests in fixed income securities. A fund manager scours the globe with their team to find attractive opportunities and add them to the portfolio. Remember that different funds can have different objectives and levels of risk. Therefore, it’s best to have a deeper conversation with your advisor about your portfolio and your overall investment goals.
[2] Why do companies issue 100-year bonds?
[3] AAA: Definition as credit rating, criteria, and types of bonds
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