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
Pro
  • 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
Con
  • 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


Fixed Income Part 3: Preferred Shares

Insofar as fixed income goes, I have already discussed two types of “fixed” income: Bonds, and Bond ETFs. There is one more category of security that I’d like to discuss, that being preferred shares.

Overview

Unlike a bond, a preferred share is not a true form of fixed income. It is, essentially, equity. However, unlike a common share, preferred shares have many similar characteristics with a bond: they pay a fixed dividend (equivalent to a bond’s coupon payment), can have several options attached to them (such as being callable or convertible), and they rank higher than common shares with regards to a claim on a firms assets. Essentially, a preferred share (sometimes called a preferred) is a class of equity that a firm issues which has a predetermined dividend payment associated with it, which is a percentage of the preferred’s original issue price. The Bank of Montreal has several classes of preferred shares which can be reviewed here, and we’ll take a look at the Preferred Class Series 5 shares for this discussion; a copy of the prospectus can be found here.

Taking a look at the prospectus, the full name of this preferred is Non-Cumulative Class B Preferred Shares Series 5, and the preferred was originally issued with a price of $25.00, and a 5.30% yield. The 5.30% is the yield relative to the original issue price, and this equates to a $1.325 annual dividend, or $0.331250 a quarter. The preferred is also non-cumulative, which means that in the unlikely event that the BMO Board of Directors elects not to issue the dividend for a given quarter, that dividend is lost forever (explained on Page 4 of the prospectus, under the Dividends section). Reading further, the preferred share is also callable on or after February 25, 2012, at a price of $25.00/share.

Not all preferred shares are callable, or non-cumulative. For example, PartnerRe Ltd. on the New York stock exchange has Cumulative Redeemable Preferred Shares, which means that if a dividend payment is missed, the missed payments accumulate until a later date at which all dividends can be paid out to the respective shareholders. Similarly, not all preferreds are callable by their respective issuers; (non-)cumulative, redeemable, callable, etc., are all covenants placed on dividends to protect the issuer. However, not paying a dividend on a preferred share sends a very negative signal to the market. At the very least, bond holders and preferred holders should be paid out of the regular earnings of the firm, and typically common shares are the first shares to be cut.

Pros

The biggest two pros of a preferred share are their regular dividend cashflow, and their ranking on the claim of the firms assets.

For cash flow, when you purchase a preferred you are “guaranteed” the dividend payout for as long as you hold the preferred, or until the firm calls and/or converts it as outlined in the prospectus. This is what places preferreds in the category of fixed income: they provide a steady, predictable stream of income much like a bond.

In the case of callable preferreds, the preferreds also preserve much of your capital. While the BMO Preferred Share sells for slightly above its original $25.00 sell price (as of this writing, the price is $25.84, the potential of losing all of your initial investment is minimal: if the price skyrockets, the issuer will pay $25.00 if they decide to call; a 3.25% loss, but if the preferred is held for at least a year your total holding period return is still net positive (e.g. if you purchased for $25.84, after one year your total income would be $1.325; even if you sell for $25.00 your return for the entire holding period is still 1.88%). And unless the company declines to pay a dividend, the price is unlikely to fall below $25.00 a share; doing so would equate to a higher yield (as the price of the preferred falls, the yield rises); supply and demand would keep the share price at or around $25.00.

Ranking on a firms assets means that in the unlikely event of bankruptcy, preferred share holders rank below bond holders, but ahead of common share holders. In terms of paying out the shareholders who own the companies equity, after bond holders are paid, preferred share holders are next in line. This is another element of protecting your capital. Within the world of preferreds, there are still rankings (e.g., for our BMO Class B Series 5, the Class B ranks only below bonds, and covenants of the preferred dictate that the bank cannot issue another series of preferred share that ranks above the Class B), but overall there are typically less preferred shares outstanding than common shares, so you are more likely to receive a piece of the pie owning a preferred share than a common.

A final pro to a preferred is that it is more accessible to the average shareholder than a bond. One of my criticisms of bonds was that they had a high initial buy-in, typically in the $1,000 or $5,000 range. Preferreds span the gamut of accessibility and can be had for as little as $25.00 a share, definitely within range of the average investor.

Cons

Due to the covenants available for preferred shares (callable, non-cumulative, etc.), one has to be careful to read the full prospectus to understand what they are getting into when they purchase a share. For example, if you purchased a BMO Class B Series 5 in January 2013, by the time February 25, 2013 rolls around, BMO may decide to start calling the shares on the common market; your fixed income vehicle may be reclaimed by the firm before you’ve even had a chance to enjoy the dividend! Likewise, if the firm declines to pay a dividend for a non-cumulative preferred for one quarter, you have effectively lost 25% of your annual income from that preferred!

Covenants aside, one of the biggest downsides to a preferred when compared to their common counterparts are the fixed payments, which was touted as a strength above. Fixed payments essentially mean that the yield dividend of the preferred is fixed for the life of the equity, which contrasts to a common share where the dividend may rise (or fall) if EPS rises (or falls). However, it isn’t fair to compare a preferred share to a common share; while they are both forms of equity, they are completely different beasts. When analyzing the capital structure of a firm, it preferreds are often lumped in with the fixed income portion, not the equity portion. For this reason, comparing a preferred to a common isn’t a true apple-to-apples comparison.

Wrapping It All Up

Preferreds over an attractive alternative for fixed income. Their biggest advantage in my eyes is the ability to act as a fixed income stream, with relatively low initial investment. In my final post, I’ll compare preferreds to bonds and bond ETFs to see how they all stack up against each other.


Fixed Income Part 2: Bond ETFs

In my last post I discussed the pros and cons of bonds. One limitation to bonds is that the usually require an investment of over $1,000, and sometimes over $5,000, to purchase, which may not be a viable option for the casual investor. One alternative to purchasing de-facto bonds is bond ETFs.

Pros

There are several bond ETFs on the market from the major ETF players such as iShares and Bank of Montreal, covering a wide range of requirements, such as government bonds, corporate bonds, real return bonds, etc. In terms of accessibility, ETFs trade on most major exchanges, and as such they are easily accessible to anyone with a trading account. Bond ETFs are also attractively priced, which puts them within grasp of those with minimal funds to invest; a small position can be created with as little as $100, a far cry from the $1,000 minimum investment for most bonds. Yields are comparable to the bonds that underlie the security, so even a small position would have a net positive payout over time.

Another advantage to bond ETFs is that they offer a good degree of diversification. A bond ETF is composed of a number of underlying bonds, the exact bonds being dictated by the investment objectives of the ETF. For example, as of August 26, the BMO Long Federal Bond Index ETF holds 11 different bonds:

Security %
Cda Govt 5.00 01Jun37 0.1893
Cda Govt 4.00 01Jun41 0.1885
Cda Govt 5.75 01Jun29 0.1847
Cda Govt 5.75 01Jun33 0.178
Cda Govt 3.50 01Dec45 0.0602
Canada Post 4.08 16Jul25 0.0549
Cda Govt 8.00 01Jun27 0.0508
Cda Govt 8.00 01Jun23 0.0333
Cda Govt 9.00 01Jun25 0.0276
Cda Govt 1.5 1Jun23 0.0238
Canada Post 4.36 16Jul40 0.0108

By purchasing a single ETF, you now hold portions of 11 bonds, greatly diversifying the risk of holding a single bond.

Cons

The biggest challenge with bond ETFs doesn’t come from the bond ETF per se, but from the structure of ETFs in general. In its simplest form, an ETF, or exchange traded fund, is a collection of underlying securities which are wrapped up as an ETF, and traded on the open market. ETFs are similar to their mutual fund brethren, two of the key differences being that ETFs trade on major exchanges, and that the key fees inherent in mutual funds (such as front load or back-end load) are represented by standard brokerage fees for trading on the exchange.

Bond ETFs being composed of the underlying bonds is the major challenge. Bonds are directly impacted by interest rates: as interest rates rise, bond prices fall, and vice-versa. Because an ETF is made up of a collection of underlying bonds, as the value of the underlying bonds rises (or falls), the ETF itself rises (or) falls in value. In a period of falling interest rates this means that the underlying bonds rise in value, with a corresponding rise in the value of the bond ETF. Interest rates are currently at historical lows, which means that over time interest rates have nowhere to go but up. As interest rates rise, the underlying value of the bonds will fall, which means bond ETF prices will fall as well.

Why does this matter? Ignoring the obvious fact that your initial investment will fall as interest rates rise, you also suffer from a loss of capital. If you buy a $1,000 par bond today, which matures in 5 years, you are guaranteed two things:

  • The coupon payments of the bond over the next five years
  • The $1,000 principal in the fifth year

However, with a bond ETF, you are not guaranteed your principal since the bond ETF never matures. If you take the identical $1,000 investment for the $1,000 bond and purchase $1,000 worth of shares of a bond ETF, if the rates fall and you sell your ETF shares, you will receive less than your initial investment.

One final drawback to a bond ETF is with regards to the “coupon” payments. Any distributions from the underlying bonds, after paying management fees (defined as the MER) should be distributed to the shareholders. However, because the ETF is composed of a number of underlying bonds, those distributions may change over time. In terms of predictable cash flow, a bond ETF may not be the best option. Looking back to the $1,000 bond example above, if the bond pays a 5% coupon on a $1,000 semi-annually, I am guaranteed $25.00 every six months. This relationship may not hold for an ETF since the underlying bonds of the ETF may change over time.

Wrapping it all up

In terms of accessibility, bond ETFs cannot be beat. They offer low initial investment costs, and offer great diversification. However, since they do not have maturity dates as with a typical bond, you risk losing portions of your initial investment as interest rates rise. Of course, the opposite is also true: if interest rates fall, your initial investment will appreciate. As also mentioned, the cash flows may not be consistent while you hold the ETF (although they may fall or rise, depending on the underlying bonds). However, given that interest rates are already fairly depressed, the likely direction of interest rates in the future is up, not down.


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.