Fixed Income Part 1: Bonds

One of the key elements to proper portfolio diversification is to ensure that you have a healthy balance of equities and fixed income, depending on your risk tolerance. for the most part, there are three types of fixed income that one may add to their portfolio:

  • Bonds
  • Bond ETFs
  • Preferred Shares

To date, my preference has been for bond ETFs, but I am starting to take an interest in preferred shares as well. This is the first of a short series of posts on my views on fixed income investing, and for this post I’ll be discussing bonds.

Bonds

There are four basic elements to a bond

  • The bond face — or par — value, which is the amount of cash that the bond is exchanged for at maturity
  • The maturity date: this is the date at which the bond matures. In other words, on this date, the bond is exchanged for its par value with the issuer.
  • The coupon of the bond: this is the rate at which the bond pays interest, relative to its par value. E.g., a $1000.00 bond with an 8% yield would give you $80.00 per year in interest payments.
  • The yield — or yield to maturity — of the bond: this is the relative return of the bond, based on what you paid for it, what its coupon is, and when it matures.

There are other components that define a bond, but these are the four key elements. For example, a bond may be annual, or semi-annual, meaning it pays interest once a year or twice a year. In the case of a semi-annual bond, our 8% yield bond above would provide two $40 payments throughout the course of the year. Another feature may be a callable bond, where the issuer of the bond reserves the right to call the bond prior to the maturity date, and exchange it for cash. Entire textbooks have been written up on bonds, but the purposes of this post the four elements above are the ones I am concerned with.

As a dividend investor, I lean towards a buy and hold strategy. For that reason, my primary concern with a bond is the yield of the bond. The yield tells me what my return will be relative to my investment at the end of the day. One key thing to note is that yield and coupon are not the same. A bond which carries a 5% semi-annual coupon (so two $50 payments per year) may a yield that is higher or lower than 5%. In its simplest form, a yield which is higher than the coupon rate indicates that the bond is selling for less than its par value; e.g. a $1,000 bond may be selling for $990. Likewise, a yield lower than the coupon rate indicates that the bond is selling at a premium; e.g. a $1,000 bond may be selling for $1,050. However, if you are holding the bond to maturity, what matters is that you hold a bond which has the required yield for your portfolio. So if, for my portfolio, I am looking for a fixed income component that pays a 5% yield (so $50 every $1,000 of investment on an annualized basis), then I will search for a bond with a yield to maturity of at least 5%.

So, say I purchase a $1,000 bond which has a yield to maturity of 5.10%, but its coupon is 8.00%; this tells me that even though the bond is paying me $80/year in interest payments, relative to what I paid for the bond, I am only receiving $50.00/year in interest payments, because I paid more than $1,000 for the bond in the first place. To demonstrate this, I’ve put a little spreadsheet up, where you can punch in bond par and selling values, to see the effect on yield to maturity. You can find the spreadsheet here.

Pros

As I see it, the strongest selling points of a bond are:

  • Bondholders hold a higher right to claim on an organization’s assets. In the unlikely event that an organization goes bankrupt or gets itself into serious financial trouble, bond holders rank above shareholders in terms of being paid back for what is due to them.
  • Bonds pay a fixed amount for the life of the bond. Once you have purchased the bond, you know exactly what you are getting, and exactly how long you are getting it for. This stability is like gold for financial planning.
  • The market for bonds is fairly liquid. If you have to sell your bond to free up some capital, you should not have much of a challenge.

Cons

As good as bonds are, there are a few cons:

  • The biggest challenge with bonds is the up-front capital investment. Bonds typically sell for at least $1,000, which is a big chunk of change for personal investors such as myself.
  • Bonds are highly (negatively) correlated to interest rates. In other words, as interest rates rise, bond prices fall. As of this writing (August, 2012), interest rates are relatively low, which means that bond prices are relatively high. But, if you buy a bond today as part of long-term buy and hold strategy, and go to sell it later when (if) interest rates go up, then the value of your bond will decrease, and you’ll be stuck with a capital loss. Investopedia has a short explanaition on this topic at this link.
  • Bond payments are fixed. While I said that bonds paying a fixed amount were a pro, above, this also means that there is no potential for the payment to increase, unlike a dividend paying stock where the organization may elect to increase the dividend payments over time.

Wrapping it all up

Bonds provide an attractive vehicle for fixed income, provided one has the cash to purchase them. You could purchase a bond on margin or take out a loan, and theoretically as long as the yield to maturity of the bond is higher than the interest rate on the loan, you would still come out ahead; I’m curious to the tax implications in doing this, since bond interest is not the same as dividend income, so there is not as much as a tax incentive to borrow to invest in them (as I discussed in my last post.) In future posts on this mini-series, I’ll compare bonds to two other fixed income instruments, bond ETFs, and preferred shares.



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