18. Investing Basics Part 2 - Bonds

Transcript:

Hello, and welcome back to the Canadian Money Roadmap podcast. I'm your host, Evan Neufeld. Today we're going to be talking about bonds.  

This is the second episode in my introduction to investing series and today we'll talk about bonds. What are bonds specifically, how do you make money with bonds and why should you possibly put them as part of your portfolio? 

 I'm going to go out on a limb here and assume that most people listening have probably heard of bonds before, but they might not necessarily know how they work.  In my experience working with clients, this is a typical experience, so you're among friends here. So let's start off with the basics of, what are bonds. 

Bonds are simply a loan that an investor makes to a corporation or a government. It's pretty much as simple as that. So when you buy a bond, that money goes to the issuer, the government or the corporation, in exchange for a set amount of interest, paid for a set amount of time. Let's use an example here. 

So say there's a $5,000, 3% bond, which matures in 10 years. This means that you would give the Government of Canada, for example, $5,000 in exchange for 3% interest payments per year for the next 10 years. At the end of the 10 years or maturity, you get your $5,000 back. 

Since the interest portion will not change during the lifetime of the bond, in my example, the 3%, it doesn't go up and it doesn't go down. You might hear bonds referred to as fixed income. Last week, when I was talking about stocks, I mentioned that stocks are sometimes referred to as equities and here bonds are sometimes referred to as fixed income.  So when you hear equities and fixed income, they just mean stocks and bonds. 

The interest portion that's payable for new bonds typically changes along with prevailing interest rates. So now that we're going to place a very low interest rates, most new bonds being issued will also be at very low interest rates. We talk about the different types of bonds, corporate versus government. 

A government bond has less risk and thus will pay less interest. Typically, it has less risk because it's backed by the government. I'll digress here by saying that this comment is a bit more relevant for developed countries like Canada, US, EU and Japan.  Countries that have a greater risk of going bankrupt or what we say defaulting on their loans or defaulting on debt.  Will have to pay more interest to get people interested in lending them money. If there's a chance you won't get your loan money back when the bond matures, you need to be paid more in the meantime to offset that risk. 

 Let's use a real-world example here. So right now, a 10 year bond in Japan currently pays 0.07%, while a 10-year bond from Turkey pays 15.5%. A higher interest rate here isn't an indicator of Turkey being a better place to invest, perhaps the opposite. This is an indicator of the higher risk of losing your money. So they have to pay you more interest in the meantime, to get you interested in lending the money. 

This is a classic example of the risk reward trade off. Now a corporate bond also has more risk, because the company can go bankrupt. So they'll have to pay more interest. So even the best companies have a greater risk of going bankrupt than most developed countries. So corporate bonds will almost always pay more than government bonds. 

So, how can you make money with bonds? Well, I've alluded to this already, but it's the interest payments is the first one. Sometimes the interest payments are referred to as yield or even the coupon rate because when you bought a bond back in the day, there used to be an actual bond certificate with little perforated coupons that you could redeem your annual or semi-annual interest payments for.  Again, because it was fixed like that that's why it was called fixed income because there used to be a physical coupon that you could redeem for a set amount of money at a given time.  

The second way that you can make money with bonds is when they change value on the open market. But since there's an intrinsic value to a bond, meaning at the end of the term, there's a set of money that would be repaid back to the lender or you as the investor. 

The prices on the market won't change nearly as much with speculation as much as with stocks. Prices will change based on changes in government behavior but more specifically with interest rates. Let's go back to an example here. 

Say I own a 10 year, 5% bond that I bought for a thousand bucks. Now as interest rates fall, perhaps new bonds are being issued for 4%. So if you, as an investor looking to buy a bond, you could buy a new one from the market at 4%, or you could buy mine for 5%. Which one would you pay more for? Well, you'd probably want to buy the one that pays more interest. 

So since mine is more valuable, now I could sell mine for say $1,050. So in this example, Interest rates fell, which made my bond more valuable because my existing bond pays a higher rate than what someone could find elsewhere. The opposite is also true. If a new bond could be sold for 6%, my old bond paying me five is a lot less interesting to investors. 

So I have to drop the price if I want to sell it. So bonds kind of move like a teeter-totter or a Seesaw with interest rates. So as interest rates go down, bond values go up and interest rates go up, bond values go down. 

So, how do you make money with bonds? The interest payment is the more predictable way, but also from changes in the market that will make your bond more valuable. 

Coming back to interest rates for a second here, to understand where we are historically with interest rates. If you're listening and you're under the age of say 45, go ask your parents what their interest rate was on their first mortgage. Because back in the early eighties interests got as high as about 18%.  Compare that to today where you can get a mortgage for less than 2% in some cases. There are a lot of factors at play here that affect why interest rates are the way they are and housing prices and things like that. But I won't get into that, but I just wanted to compare where interest rates were. 

So they dropped from 18 down to two and as you can imagine, so rates have been dropping steadily since the eighties. So during that time, if you own bonds, you could actually make some money, both ways from interest and from the value of your bond, increasing in value relative to the market. But now that we're at an all-time low in interest rates, we don't really have anywhere to go, but up. 

So it's going to be a tough place to make money from fixed income or from bonds, yields are very low on low risk bonds and interest rates are more likely to go up instead of down. 

Knowing that why should you bother owning bonds? Well, historically speaking, stocks and bonds have been loosely or negatively correlated. Now that sounds a little academic here, but essentially that means that if stocks go down, bonds go up and vice versa. It's never been perfect and it's getting less and less so that way, but the idea was if your stock portfolio takes a hit, you'd also want to be owning something that might increase in value. 

At the same time, the second reason I might want to own bonds is that they decrease your overall risk in your portfolio. 

Since there's a known value of a bond, meaning that amount that will be paid at the end of the term bond prices can only really move so far. So they are a far less risky place to invest. I'm not saying no risk, but less risky than stocks for sure. A little side note here regarding risk with corporate bonds.  So if a company goes bankrupt and you own the stock, you're not likely to receive any money for your ownership in that company. However, if you own that company's bonds, meaning they owe you money. You become the first payer of any money that they can recover via bankruptcy. So if they sell buildings or other assets, since you lent the money in the first place, you still have a chance of getting some of your money back.  It's not perfect or guaranteed, but it's a layer of risk reduction compared to owning the stock. 

In the past you've wanted to own bonds because you could actually make money with them. However, in this current market, you wouldn't own bonds to make a significant amount of money in the long-term. I guess you could want to, but realistically speaking, it's not likely to happen. 

But now you'd own bonds just for their ability to decrease your overall risk and still get paid a little bit of something in the meantime, they'll pay more than cash sitting in the bank. Anyways, think of bonds like airbags for your portfolio. A crash can still hurt, but an airbag might give you the protection you need. 

So you can imagine that if you don't have the risk tolerance for the ups and downs of the stock market, including some bonds in your portfolio, will help smooth out the ride along the way. Typically, as people get older and they're going to need to start withdrawing from their investments to spend after they've retired or things like that, you might want to consider, increasing your portion of bonds in your portfolio to make sure that risk is decreased over time. The more you need to rely on your portfolio for income. 

So let's summarize here. What are bonds? Bonds are just a loan that you would make to a government or a corporation in exchange for interest over time. My example there $5,000, 10 year, 3% bond means that you're going to get 150 bucks for 10 years. And then at the end of the 10 years, you get your $5,000 back. 

So how do you make money with bonds? Well, that's the first way is that yield or the coupon rate or the interest payment, all essentially refer to the same thing, but your bond can also increase in value as interest rates change over time. Again, we've got that inverse relationship as interest rates go down, but on values go up and as interest rates go up, bond values go down. 

And so why should you own bonds? In this current market environment, the typical reason for owning bonds would be to just decrease your risk over time. There's a little bit less correlation between the stock market and the bond market. So you have the ability to make a little bit of money when stocks are looking ugly, but more often than not, you will want to include bonds in your portfolio, for the risk mitigation factor, considering where we are in the current interest rate environment. 

Thanks for joining me today on the Canadian Money Roadmap podcast. If you enjoyed today's episode, I'd really appreciate if you left me a review on Apple podcasts with your biggest takeaway. If you have questions or ideas for topics you'd like me to discuss on future episodes, please reach out via my contact info in the show notes. 

This podcast is intended to be educational in nature, and you should always consult your financial team, Tax and legal advisors before making changes to your financial plan. Any rates of return discussed are historical or hypothetical and are to be used for educational purposes only. Evan Neufeld is a Qualified Associate Financial Planner and registered investment fund advisor.  Mutual funds are provided through Sterling Mutuals Inc.