Fixed income is an asset class that is misunderstood by a great many investors and it is worth spending some time learning more about it.
Regardless of the issuer, all fixed income investments pay an interest rate and repay the principal at a pre-determined maturity date. The interest payments are a contractual obligation, as is the repayment of the principal.
Fixed income investments include bonds (or debentures) and GICs. Bonds can be issued by governments and corporations, both domestic and foreign.
Each will have slightly different characteristics from the others. In the case of corporate bonds, interest payments are made from pre-tax income, while government bonds are paid from tax revenues, but they are all bonds.
Since all fixed income investments carry the same two major characteristics, an interest rate and a maturity date, they belong in the same asset class. Some of the secondary characteristics of a bond can include an inflation adjustment component, the opportunity to convert the bonds into common shares, or a variety of other characteristics.
Some financial services firms and publications have advocated different asset classes for the purpose of recognizing the unique features that a bond may offer.
However, splitting fixed income investments into several different asset classes doesn’t change these two major characteristics. If the decision is to split fixed income investments into completely separate asset classes because of a unique feature, then it would be difficult to stop at five.
Challenges in the bond market
Despite rarely making the headlines in the financial media, the bond market is significantly larger than its more glamorous partner . . . the stock market. This is partially due to the fact that governments issue bonds when they need to borrow money; they don’t issue stocks, and the government bond market is enormous.
With the size of the bond market, it seems like it should be relatively easy to find the appropriate selections for a portfolio. That isn’t always the case. Pension plans, mutual funds and other institutional investors will often swoop in and pick up large quantities of the best bonds. Banks will also get in on the action. They might pay a nominal interest rate to a customer on a savings account and use the proceeds to buy a higher yielding bond. They can earn a tidy profit by capturing the ‘spread’ between the two interest rates.
So the average investor has lots of competition when it comes to buying bonds.
There are other challenges when it comes to buying bonds. There is no central market as there is with the stock market, so even trying to find what is available can be a challenge. There are also other administrative factors to consider, such as re-investing interest payments and finding new bonds to replace those that are maturing in a portfolio.
Unlike stocks, bonds have a maturity date and the profile of a bond portfolio changes over time if no action is taken. Over time, a ten-year bond will become a five-year bond, a two-year bond and eventually cash.
In order to ensure that a bond portfolio has a relatively constant profile it must be actively managed.
An investor can buy and hold a stock literally forever. The same cannot be said for a bond because it will mature.
A Closer Look
On the surface, bonds and GICs may seem simple to understand. They pay an interest rate and they have a maturity date; it is a simple concept to grasp. It provides a level of comfort. But there are valid reasons to scrutinize the fixed income market more closely.
In a rising interest rate environment short term bonds perform better than long term bonds; in falling interest rate environments the reverse is true. At times corporate bonds perform better than government bonds, while at other times government bonds are the better investment. What are the implications of buying a bond at a premium or a discount? How do real returns bonds perform in various market conditions? How can credit quality be checked and what credit quality is appropriate? When should GICs be used rather than bonds as a fixed income investment in a portfolio?
Investors will often focus on the maturity date. They know what the yield on a specific bond will be over that time but once that bond matures, they have no idea what the opportunities will be going forward.
In addition, if more than one bond is held in a portfolio, an overall yield to maturity for the portfolio cannot be calculated. For example, if an investor holds a 3-year bond or GIC in their portfolio and a 5-year bond in their portfolio, they cannot calculate what the return will be for the next 5 years because the bond that matures in 3 years will have to be re-invested and no one knows what the rate will be.
The tendency is for investors to consider each bond individually and somehow extrapolate that in a yield to maturity. With several different maturity dates and several different yields to maturity, that calculation is impossible. The current yield on each bond, however, can be calculated in the same way it can be calculated on a bond mutual fund or a bond ETF (exchange traded fund).
Once an investor holds more than one bond in their portfolio, it is akin to holding a bond mutual fund or a bond ETF. In the first case, the investor makes the choices for the individual bond investments and in the second case the manager of the mutual fund or ETF makes the choices. In both cases, a portfolio of bonds holds each with varying maturities, interest rates and other features.
If you could take a can opener and open up the portfolio of a bond mutual fund, the yield to maturity of every bond in that portfolio could be calculated and listed on a spreadsheet. In fact, for those who want to take the time to glean through an annual report, it could be done . . . not in a timely fashion, but it could be done.
Bond mutual funds and bond ETFs do provide statistical information on the bonds in their portfolios. The current yield of the bonds, the average duration and the credit quality of the bonds are released on a regular basis. The name of the actual issuer of each bond in the portfolio is also listed.
For the core holdings of a fixed income portfolio a mutual fund or ETF can help to reduce the administrative chores, eliminate the task of choosing which of the many individual bonds are appropriate and provide instant diversification across issuers, maturity dates and credit quality. That doesn’t mean there aren’t excellent opportunities among individual bonds because there are.
Investors have to decide for themselves which approach works best or if a combination of mutual funds, ETFs and individual bonds is the most appropriate.
Sticking to GICs has its drawbacks; the major one is lack of liquidity.
When an investor chooses a five year GIC, for example, that money is inaccessible for five years. If an emergency arises, if the investor’s goals change, if the investor decides to make a major purchase or if a better opportunity arises, the money invested in that GIC is not available. This restrictive feature should not be overlooked or underestimated.
On the other side of the coin, most GICs carry a guarantee of principal and interest subject to certain limitations. If an investor does choose a GIC, it is important to be aware of the terms of the guarantee.
All of this illustrates the complexities of the bond market. It can be very rewarding and, managed properly, it becomes an important part of an investment portfolio. A financial advisor can help walk investors through all the options and provide them with some direction when making those difficult decisions.
Fixed Income Valuations
Like cash, bonds are affected by inflation. Because the investor has ‘lent’ their money to the bond issuer for a longer period of time, there is a greater risk that something unforeseen could happen to the issuer, making repayment difficult. As a result, the investor typically demands and gets a higher rate of return on longer term bonds. It is a premium received for the risk assumed by the investor.
Here is where bonds get tricky and where the misunderstanding often occurs among retail investors with regard to the rate of return on their bonds.
We can take the hypothetical example of an investor who buys a $10,000 fifteen year bond that has a coupon of 5%. All else being equal, the investor will collect his interest on a regular basis and the principal will be paid at maturity, in fifteen years. It is at the point in time when the issuer redeems the bond, not before and not later.
But interest rates never remain constant and over a fifteen year period there are likely to be periods when interest rates are high and periods when they are low. However, this hypothetical investor has purchased a bond that will pay $500 interest year after year. But the investor may want to sell his bond before it matures.
Should prevailing interest rates rise to 7% and the investor want to sell his bond prior to maturity, there wouldn’t be a lot of interested buyers. After all, why take $500 per year when you can go elsewhere and get $700 per year ($10,000 x 7%)?
In order to make his bond attractive to buyers, the investor would have to sell it at a discount and that discount would be of sufficient size that the total return to maturity would be 7%.
Conversely, if interest rates had dropped to 3%, the investor would have buyers clamoring for his bond.
But why would an investor give away a 5% bond when everything else was paying only 3%? The short answer is they wouldn’t. In this case, the investor who bought the bond could command a premium price for his bond.
The chart below illustrates how the price of a bond changes with interest rates. In this example the bond was purchased at $100 with a 5% annual yield and term to maturity of fifteen years. As interest rates fluctuated between 3% and 7%, the value at which the investor could sell the bond would also fluctuate.
In the end it would mature at $100 and the investor would have collected 30 semi-annual interest payments of $2.50 each for a total of $75 along with the original $100.
You will notice that fifteen years prior to maturity a change in current interest rates has a far greater impact on bond prices than it does two or three years prior to maturity.
The market price of a bond listed on a client statement reflects the price of that bond if it is sold prior to maturity. It does not reflect the price at maturity. Any bond sold prior to maturity runs the risk of being sold below its purchase value. There is also an opportunity for the sale of the bond at a premium at some point. The longer the term of the bond, the greater the chance of one of those situations arising.
The principal value of a bond mutual fund will fluctuate with interest rate changes in much the same way as the principal value of an individual bond fluctuates.
As you can see, the value of a long term bond will fluctuate in value much more than a short term bond but mutual funds are different. When you first buy a long term bond it can be very volatile in price but that volatility will fall as the bond approaches maturity.
Bond mutual funds will act somewhat differently. The managers usually keep the duration in a pre-determined range. Long duration funds will always hold bonds with longer terms to maturity, and conversely, short duration funds will hold short term bonds. Because the duration remains relatively constant over time, the potential volatility of a bond fund will also remain relatively constant and won’t decrease over time.
An investor who expects interest rates to rise would hold shorter term bonds, while the investor who expects rates to fall would hold longer term bonds. Bond yield calculators allow you to calculate the impact of interest rate changes on the value of your bond portfolio.
Keep in mind that this change in value represents the change in the principal value of the bond and not in the interest it pays. A bond can fall in value but given a high enough interest rate, it can still provide a positive return. The principal value of a bond can also rise and when added to the interest earned, it can provide a return in excess of the coupon (interest) rate.
If you purchase a long term bond, its value could swing substantially prior to maturity but as it nears maturity, the price becomes more and more stable, eventually maturing at its face value. At any point before maturity, however, the price of the bond could be above its face value or below its face value depending upon the interest (coupon rate) rate of the bond and the current interest rates.
Of course, when valuing bonds and anticipating how they might perform going forward, other features and characteristics of the bonds need to be considered. Do they have a high coupon rate or a low coupon rate? Are they trading at a premium or a discount? What is the credit quality of the bond? Do they have a step-up feature? Are they a fixed-rate bond or an inflation adjusted bond? Are they convertible?
One of the most disconcerting things that can happen to an inexperienced investor is to see the market value of their bond portfolio dropping. It seems incomprehensible that a supposedly safe investment could drop in value but it happens frequently as interest rates fluctuate.
A common reaction to the movement in bond prices can be a retreatby some investors back into GICs. Each statement comfortably lists the purchase price of the GIC without any price swing. Of course, the price is an illusion because it does not reflect the price an investor would realize if they tried to sell the GIC prior to maturity.
A GIC is a non-marketable investment. The institution which issued the GIC will not redeem the GIC prior to maturity except in the most extreme cases and often with a penalty, regardless of whether interest rates have moved in favor of the investor or not. Bluntly put, many investors are deluded into thinking that their GIC portfolios have more price stability than a similar bond portfolio.
It simply appears that way because the actual price that an investor could receive on a GIC prior to maturity is not published.
The fixed income space can be very rewarding but it involves more than shopping for the best rate on GICs. It is an area where a financial advisor can provide some meaningful guidance and a good fund manager can add value.