Risk and Choice in Fixed Income Investing
Introduction to Investment Planning – Part 2.2
In my previous post I wrote about some of the basics of bonds as well as their benefits. This post continues the discussion with an examination of the risks of investing in bonds and the ways you can buy bonds.
Some Risks of Investing in Bonds
Interest rate risk
If you own a bond that pays 5 percent interest, what happens if interest rates go up and you can now buy bonds that pay 6 percent? You will probably sell the 5 percent bond and buy the 6 percent bond instead. You won’t be alone, though. If interest rates go up, all things being equal, existing bond prices will go down. You may have a capital loss because you won’t be able to sell the bond for the price you bought it at because that bond no longer has the same value it once did.
Inflation risk
A bond is a “fixed income” investment. That is, you are promised a specified (fixed) rate of interest (income) when you buy the bond. What happens, though, if you buy a $100,000 bond which pays 5 percent interest each year and it matures in five years. You are getting $5,000 per year in interest which seems pretty good, in and of itself. In five years, you will have received almost $128,000 if you reinvest your interest payments. But what if inflation is running at 7 percent a year? You would have needed to receive $140,000 just to keep up with inflation.
Default risk
Although this is unlikely to be a risk with government bonds (at least in Canada), corporations may default on their debt repayment if they run into trouble. The higher the rating of the bond, the less likely this is to be a concern. DBRS, formerly known as the Dominion Bond Rating Service, is a well-known Toronto-based credit rating agency. They use a letter rating to identify the risk of default. The following is a very brief summary. Please read here to learn more about the ratings:
AAA – highest credit quality
AA – superior credit quality
A – good credit quality
BBB – adequate credit quality
—– anything below this line is considered non-investment grade —–
BB – speculative, non-investment grade credit quality
B – highly speculative credit quality
CCC/CC/C – very highly speculative credit quality
D – bankruptcy filed
Liquidity risk
Unlike Guaranteed Investment Certificates (GICs), bonds may be bought and sold throughout their lives. Holders of government bonds are usually able to find a buyer, but corporate bonds may not be so easily bought or sold. I have contacted the bond desk where I used to work, seeking the purchase of a particular bond for a client, only to find that none were available. If you wish to buy a bond that is thinly traded, you may have to pay a higher price than you would for a similar bond that has a ready market. By the same token, you may have to accept a significant discount if you wish to sell a bond that has few buyers.
How to invest in Bonds
Individual Bonds
You can buy individual bonds through your brokerage if you wish. This is usually not the most efficient way to do so, however. The bond market is dominated by institutional investors (mutual funds, pension plans, endowments, etc.) who buy bonds in large quantities. Retail investors in individual bonds who buy smaller quantities will most likely find a wider spread between the price to buy vs. the price to sell. With these extra costs, assembling a properly diversified fixed income portfolio can become quite expensive.
Bond mutual funds
Another way to buy bonds is through mutual funds. A mutual fund is an institutional investor and therefore has the buying power to purchase many bonds at a reasonable price. There is a wide variety of bond mutual funds out there. Some will be actively managed, by which I mean they will seek to do better than a particular index of bonds, while others will be passively managed and seek only to replicate the returns of an index. Actively managed funds tend to be more expensive than the passively managed funds.
Bond Exchange-Traded Funds (ETFs)
Bond ETFs are very similar to mutual funds in that within the ETF, a manager will have purchased a number of bonds, potentially the universe of bonds in the Canadian market. Other ETFs will only invest in a section of the bond market, for example, government bonds only, or 1-to-10-year bonds only.
What’s the difference?
The big difference between mutual funds and ETFs has to do with how they are bought and sold. In the case of mutual funds, you are trading directly with the mutual fund company, although you may be going through your mutual fund dealer or broker. Exchange-Traded Funds, however, are bought and sold on an exchange through the services of a broker, and the other side to your trade is quite likely another investor.
Although some people will still choose to buy individual bonds directly rather than hold bonds through a fund, for most of us, the better choice is to use a mutual fund or ETF. If you are buying an index ETF, you may get over 1,000 separate bonds with a single purchase. If you choose a specialized actively managed mutual fund or ETF, you may have fewer than 100. Either way, you are getting more diversification than you would if you bought 10 individual bonds of $10,000 each.
Scratching the Bond Surface
These two posts about fixed income have really only scratched the surface. The fixed income market is huge, larger than the global stock market in terms of their relative dollar values, and the variety of fixed income investments is no less diverse. You may have heard of T-bills, commercial paper, Eurobonds, or strip bonds. In terms of mutual funds or ETFs, you may have heard of money market funds, high-yield funds or real-return bond funds. These are all forms of fixed income investments, but they are beyond the scope of these posts.
In the meantime, if you have some questions about how investments fit into your overall financial plan, click here to contact me for an appointment.
Disclaimer: This blog post is intended for general information and discussion purposes only. It should not be relied upon for investment, insurance, accounting or legal decisions.