What is a Fixed Income Investment?
Introduction to Investment Planning – Part 2.1
Bonds are fixed income investments
“Stocks and bonds”: These are the basic building blocks of an investment portfolio. I will write about stocks in an upcoming post, but after my discussion of cash or cash-like assets (e.g., savings accounts) in my previous article, I thought it best to take the next rung upward on the risk ladder.
When you lend money to a friend, it is usually a small amount for a short term. An example might be when you go out to a restaurant together with several of your friends. A friend sitting beside you suddenly leans over to you and asks, “Can you pay for my meal? I forgot my wallet and my phone. I’ll e-transfer you the money tomorrow.” As your friend is not in the habit of asking for this sort of thing, you trust him and cover his part of the meal, which comes to $40. It’s not a lot of money and it’s only for one night. You will be content with getting your money back.
What would your response be if your friend asked to borrow $40,000 from you as seed money for a new business venture of his and said he would pay it back in four years? That is not a small amount of money. Furthermore, you could be using that money for some other purpose during those four years so not having it at your disposal is a kind of hardship. You would probably ask for more than $40,000 in return.
You and your friend agree on a rate of 4% interest per year over the four years and that he is to pay you the interest semi-annually (every six months). That works out to $800 for each interest payment. After you’ve lent your money to your friend, these are the payments you expect in return.
|Year 1 Payment 1||Year 1 Payment 2||Year 2 Payment 3||Year 2 Payment 4||Year 3 Payment 5||Year 3 Payment 6||Year 4 Payment 7||Year 4 Payment 8 + Return of Principal|
This is essentially a description of a bond. You have bought a bond from your friend. In return you get eight semi-annual payments of $800 (a fixed income) for the life of the bond and when the bond matures, you get your principal back.
Bonds are issued by a variety of entities. Governments are among the biggest such borrowers of money. They are also the most secure, so you are likely going to get a lower interest rate from a government bond than you will from a corporate bond. Government of Canada bonds are the most secure and are consequently given a AAA rating.
Provincial bonds will have a lower credit rating but are still considered investment grade. For example, the Province of British Columbia has a AAh (h = high) rating on its bonds, while the province of Newfoundland and Labrador has an Al (l = low) rating. Consequently, in order to attract buyers to its bonds, the lower-rated issuer must offer a higher yield.
There are other government sources of bonds, such as from cities (municipal bonds) or government agencies (agency bonds).
Corporate bonds, as the name suggests, are issued by corporations. Rather than issue stock, that is, equity or a share of ownership in the company, management chooses to raise money by borrowing it in the form of issuing bonds. Since companies are not governments, they do not have the ability to raise funds through the power of taxation. Therefore, they are not as credit worthy as government entities and will most likely have to offer higher interest rates to attract investors to their bonds.
Why invest in Bonds?
Beyond collecting the interest that is due to bondholders, bonds provide at least two benefits that make them a good partner for investments in stocks. The first thing they provide is stability. Stock markets can move up or down dramatically in a single day. Individual stock prices can move even more. Bonds tend to be much less volatile. If you own a 50/50 portfolio of stocks and bonds, and the stocks you invest in drop an average of 5 percent, while the bond portion of your portfolio barely moves, you have only had a decrease in value of 2.5 percent. That stability can be very reassuring.
The second thing bonds provide is a counterweight to equities. When stock markets drop, people tend to seek safety, and since bonds are perceived as safer than stocks, people buy bonds. When bonds are in demand, bond prices go up. In the scenario above, where your stock investments decline by 5 percent, your bond investments might go up by 2 percent. The net loss of your overall portfolio might then be no more than 1.5 percent.
A third benefit is the interest received from bonds. These days, with interest rates so low, that does not seem like much of a benefit, but added onto the potential for growth in value if interest rates drop, even low interest rates should not be ignored.
In sum, bonds are a good diversifier that often make sense when paired with riskier, more volatile equity investments.
More to come on fixed income investing in the next post.
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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.