Fixed Income Part 4: Wrapping It All Up

In this short series I’ve talked about three types of “fixed income”: Bonds, Bond ETFs, and Preferreds. Of the three, bonds are the only true fixed income securities. But, which is best, and why? The following table summarizes the results:

Bonds Bond ETFs Preferreds
  • The only true “fixed-income” vehicle
  • Preserves capital (if held to maturity)
  • Regular, predictable interest payments
  • Easily accessible; traded on most major exchanges, and carried by virtually all brokers
  • Offers incredible diversification
  • Wide range of vehicles (corporate, government, long, medium short-term, etc.)
  • Easily accessible
  • Regular, predictable interest payments
  • Typically trade near their par value
  • Ranks above common share holders
  • May have covenants attached which are not good for the bond holder
  • Typically high cost of entry ($1,000 or $5,000 is the typical minimum purchase)
  • Not all brokers carry bonds, or a full inventory of bonds
  • If traded before maturity, value of the bond may fall (or rise) with rising (dropping) interest rates
  • No preservation of capital
  • Share price of the bond ETF will fall (rise) with rising (dropping) interest rates
  • Interest payments may not be consistent
  • May have covenants attached which are not good for the preferred holder
  • Sometimes thinly traded; bid-ask spread may be huge
  • Technically, does not preserve capital

So, where does this leave us?

For a long-term investment strategy, given the choice, and provided I the capital were available, I would recommend bonds.  The key point about buying bonds however, is that they are best if held to maturity.  If you start trading bonds on a daily basis, you are subject to interest rate risk; one “bad” announcement from the Bank of Canada about increasing interest rates, and the market value of your bond could drop by a large percentage. This means that you would have to pay careful attention on a daily basis to changes in interest rates, which is counter to a buy-and-hold strategy.

In the interim, if you do not have access to considerable amounts of capital, I would lean towards preferreds.  While they are not bonds per se, I believe that they will preserve their value in a market with changing interest rates.  However, as I type this, I wonder if this is truly the case.  For the time being, I’ll stick by my belief, but this warrants further research.  The key thing is that with the bond ETF, your investment capital will definitely change as interest rates change, and that is due to the underlying securities which make up the ETF.  Whether the value of the investment capital rises or falls, depends on the movement of interest rates.

Full Disclosure: Long XBB.TO

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