This is a column by regular contributor Clark

If you had read Part 1 of the primer, you would have learned about the basics of bonds and their different types. Bonds offer a reasonable rate of return, though lesser than stocks, and provide protection against volatility. So, is an investor, willing to settle for lesser returns in exchange for better sleep, safe with bonds? Yes, if we turn a blind eye to interest rate risk!

### Interest rate risk

The Bank of Canada sets interest rates and other banks determine their prime rates based on it. Interest rate risk refers to the change in value of an interest-earning instrument like bonds due to variability in interest rates. Typically, as interest rates rise, bond prices fall and vice versa. An example may help to understand better.

Say, a 3-year bond valued at \$100 pays 3% interest in the current environment. If interest rates rise by 1% after a year, 2-year bonds would pay 4% whereas our bond would still pay 3%. Why would an investor buy our bond when he can get a higher rate? The only way to make our bond worthwhile would be to lower the value (price) of the bond, so that the difference in price will offset the higher interest rate existing at that time. In our example, the 2-year bond would yield \$4 per year in interest for a total of \$8 over 2 years + the principal of \$100 at maturity. If the price of our 3-year bond is lowered to \$98.10, then the investor will earn \$6 in total interest over 2 years + \$1.90 in capital gains (since he will receive \$100 at maturity), which would equal the return of the 2-year bond.

The variation in bond value occurs because the investor receives a fixed return in relation to the market. If the market (interest) rate goes down, then the bondholder owns a security that is worth more, since the new bonds would offer a lower rate of return and vice versa. The duration of the bond is a key factor in determining risk. While all bonds are affected, longer term bonds take a more severe hit because of their duration to maturity and the possibility of facing more fluctuations. It is true that the variation could go both ways but I’ll point to more knowledgeable commentaries for reference.

### Suitability for portfolios

1) Retirement portfolios are good candidates where the investor would prefer a fixed income while safeguarding the principal. The percentage of bonds may vary but it is critical to have a few.

2) Short-term needs. Saving for goals that would require the money in 3 – 5 years through the stock market would not be prudent due to market volatility. Bonds are also likely to face interest rate risk or defaults but buying a short-term bond ETF would ensure a healthier return than savings accounts and maybe, GICs too (will depend on the term that the money is going to be locked in). With depressed rates offered by savings accounts, this strategy may seem enticing but may not work for many people as there is the chance of principal loss, albeit less than equities. The bond ETF could go down in value due to interest rate fluctuations and bond return may also drop. As always, due diligence is required!

### How to buy bonds?

Bonds can be bought individually, as index funds or ETFs. Typically, individual bond issues require a minimum investment of \$5000 or more. Buying a bond index fund or ETF offers diversification by holding a selection of investment-grade government and corporate bonds. In addition, a bond fund or ETF is liquid and can be redeemed at any time (commissions have to be accounted for!), whereas individual issues may not be as liquid and have high bid-ask spreads.

Readers, do you hold individual, index fund or ETF bonds? If you’ve got tips about investing in bonds, please do share in the comments.

About the Author: Clark is a twenty-something Saskatchewan resident employed in the manufacturing sector. He repaid around \$20,000 in student loans and has been working to build his investment portfolio as a DIY investor (not trader) while nurturing plans to retire early. He loves reading (and using the lessons learned) about personal finance, technology and minimalism.

1. Vern on July 26, 2010 at 9:55 am

My short term savings for a house are in TD Canadian Bond Index – e-series.

2. Canadian Capitalist on July 26, 2010 at 11:46 am

Thanks for the mention. I personally use short-term bonds in our portfolios because I agree with the contention that longer term bonds have not provided sufficient extra returns for the risk you are taking.

@Vern: The TD e-Series Canadian Bond Index is *not* a short-term and is not ideal for short-term savings. It is equivalent to purchasing a medium-term bond since it tracks the universe of Canadian bonds.

3. Vern on July 26, 2010 at 12:00 pm

Thanks for the reminder that the TD -e-series Canadian Bond Index is not really a short term vehicle. I also have cash savings to make up for any potential principle losses. I’m mainly using the risk factor of the e-series funds to test my metal when it comes to investing. I figure if I can’t take the risk of a bond index then I won’t sleep later on if I move into ETFs.

4. saveddijon on July 26, 2010 at 12:08 pm

Right now buying a bond fund is risky given that interest rates are rock bottom and can only go up. But I might want to lock in at say 3% or so and buying a bond and holding until maturity doesn’t have the same risk, unless you need to get out early.

5. Financial Cents on July 26, 2010 at 12:26 pm

Good post!

I like some XSB in my RRSP. Not because it rhymes but because I like a portion of my RRSP holdings to survive interest rate hikes. I also like some XBB. Other these holdings in my registered accounts, I don’t own bonds. I keep cash. I figure if the market really crashes (I mean down 5,000+ points) everything including bonds is going down with it, so bonds aren’t much help anyhow.

6. FrugalTrader on July 26, 2010 at 12:49 pm

My fav short term bonds are claymore laddered bonds, CLF (govt) and CBO (corporate). What I like about CLF is the extremely low MER.

7. colin on July 26, 2010 at 1:33 pm

what happens to the bonds a person holds if the company is taken over? or what happens if the company suddenly comes out with news that they are having problems and may go bankrupt…similar to enron or worldcom where the books were cooked. I assume the bond prices would drop. could a person get out and cut their losses? (would there be a buyer on the other end)?
these are some of the questions I have with bonds, just starting to learn more about them

8. Clark on July 26, 2010 at 1:51 pm

Thanks for the comments.

I’m looking to put away some cash for a short-term goal (3-5 yrs) and thinking if bonds would be the way to go. Yes, there is the chance of principal loss but there is also an upside when compared to GICs and savings accounts. I have only looked at iShares’ bond ETFs but maybe, I should look at Claymore too since FrugalTrader is partial to them! :)

9. BadCaleb on July 26, 2010 at 3:08 pm

I hold XSB or CLF for short term holdings and so far have only PHN High Yield Bond fund in my RRSP. For my 401k, I use Pimco Total Return and Vanguard Total bond fund. However, I am slowly moving my Pimco to Vanguard for it’s excellent 0.07% MER. I would like to learn more about bonds and how to purchase them. I like the idea of building a bond ladder and will look into doing this for my Canadian bond portion of my investments whenever it grows large enough.

10. Bucky on July 26, 2010 at 4:28 pm

What hasn’t been mentioned is what happens to bonds in an inflation or deflation scenario. Inflation has been benign recently but I was an investor in the 70’s when bond prices were dropping like a stone. I think in deciding a bond allocation one has to consider future inflation/deflation prospects.
Also not discussed is default. Governments as well as corporations can and do default. Do you trust the rating agencies after the results of the past two years?
What gov’t. bonds are in your ETF? Any Greek or BP or CDO?
Thanks but I will stay with Cdn dividend stocks and keep my tax breaks

11. Bucky on July 26, 2010 at 4:36 pm

In a takeover the bondholders of the company being taken over usually have the acquiring company assume the debt obligations but not always. You have to read the proposal.
A bankruptcy is different.The bondholders rank ahead of the equity holders but behind the secured credit holders like the gov’t. Most often the bondholders will receive something but seldom full value for the bond.
I either case there is no market for the bonds

12. Clark on July 26, 2010 at 6:25 pm

@Colin: Good questions! If a company goes bankrupt, then the bondholders are second in line to be paid. Secured creditors with collateral get first preference, followed by bondholders while stockholders bring up the rear (assuming enough money is available for all!). If it is a Chapter 7 (bankruptcy) filing, then bondholders should receive a portion of their investment. If it is a Chapter 11 filing, then the bonds may trade, but the investor will not receive any interest or principal. In other words, the company defaults, causing the bond value to drop! Unless you have insider information about the company, I don’t know if you would be able to find a buyer to cut your losses. Of course, there may be some very knowledgeable investors who know something that you don’t and offer to buy even after the bad news gets out!

13. JFG on July 26, 2010 at 6:30 pm

I’m just glad you generated a little buzz on the bonds. No, they are not sexy and wild, but a portfolio with no income, is well (for me, anyways) not a portfolio.

14. Cristian on September 1, 2010 at 1:00 pm

Hello everybody,
I have a question for anyone who cares to answer…
I may be missing something, but there are several income instruments that I know. There are bonds of course, but then there are preferred shares and there are also dividend stocks. (There are also savings deposits and GICs but they are not worth mentioning since they don’t even keep up with inflation).
Why would one choose to buy bonds and have the income taxed at maximum rates, when investing in preferred shares or dividend stocks would bring a similar (if not, often, bigger) income with significantly smaller taxes?
Especially for someone who is investing long-term goals and is willing to stick to the dividend-paying stocks through thick and thin (and provided that they are carefully selected based on fundamentals), what matters at the end of the day/month/year is money left in the pocked after taxes.
Am I missing something?…

Thanks for any input,
Cristian

15. Rupert Rode on September 1, 2010 at 3:00 pm

Bonds are more secure than dividends. Dividends can be reduced at any time, while bond interest is fixed. If the company runs into financial trouble, the bondholders are secured investors, and get paid out before any shareholders.

In addition, the bond interest rates for a company are usually higher than any dividend rate for the same company. Dividends are paid out of after-tax earnings of the company, while bond interest is paid out before taxes.

16. Clark on September 1, 2010 at 8:53 pm

@ Cristian: Rupert beat me to it but another factor is diversification. I see that you are talking about long-term goals; yes, one could have 100% stocks in their 20s and ride out a recession. As one ages, there is a need for stability due to dependents and commitments. Bonds offer the peace of mind through less volatility, albeit at lesser but stable returns than stocks.

Bonds are tax-free in your TFSA and bonds in your RRSP are only going to be taxed at your marginal rate upon withdrawal (hopefully at retirement). Only when you hold bonds in your taxable account are you going to be taxed on 100% of the income. The link below may help with your asset allocation.

https://milliondollarjourney.com/portfolio-allocation-rrsps-tfsas-and-taxable-accounts.htm

17. Cristian on September 1, 2010 at 11:39 pm

Thank you for the replies, and sorry, it is my mistake that I didn’t mention that I was talking about non-registered investments (and to make it even more complicated, non-registered investments inside a corporation).
I understand diversification, but it seems to me that if the sum allocated to income investments is spread between a number of blue-chip dividend stocks after a serious analysis of the financials of each company the risk that Rupert was talking about is diluted. What is the chance that several such companies are going to fail all at once? On the other hand, nothing prevents me from switching to a different company once I see that the dividend of a certain company is reduced…
Inside the corporation dividends are taxed at 33% and that goes down to zero once dividends are paid to the corporation shareholders (at least that is what understand) while income from bonds is taxed at maximum corporate rates (almost 50%).
In other words, we are comparing a certain loss of 50% of my income with a hypotetical loss (if the company fails, if the dividends are reduced, and the list could probably continue).
If the stock market goes down, my dividend stocks would go down too, but the dividends would still be coming in (as it happened with a lot of companies in the recent downturn) thus diminishing my losses by the amount of the dividend.
And when we’re talking long-term (15 years or more) with a good risk tollerance, to me dividend stocks seem somewhat of a no-brainer…

18. Clark on September 2, 2010 at 9:22 pm

@Cristian: I do not know about the tax rates for a corporate structure but I’ll go with what you mentioned. Yes, in a non-registered account (inside a corporation or not), bonds are not the wise choice. I agree that a wholesale failure of well-researched, diversified individual stocks is unlikely. The drawback to such a strategy is if a market crash occurs in the last year or two before withdrawal from your long-term portfolio. While you can take solace from the minimized loss due to the dividends, how long can you postpone your withdrawal (selling) from that account until the recovery happens? Of course, if you have such a high value in that account that the dividends would still cover the needs, then it is another story.

If it is just bonds vs. dividend stocks in a taxable account for the long-term, then dividends win. But, for an investor’s overall portfolio, bonds or some other form of fixed income component in a tax-sheltered account would be essential to ride out the rough periods.

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