The Risks with Bonds
Posted by Gail | Filed under Investing
New Sticky Situation at the end. Also, Question 2 in our new feature on the Success Post called Thinking Things Through. Head on over and add your 2 bits. And remember to vote on this week’s poll.
Since a bond’s return is based on time and interest rates, bonds suffer from interest rate risk. If rates fall, a bond’s price rises because it becomes more valuable as a source of higher interest rates. So you can sell it for a capital gain. Or you can hold it till maturity for a great (higher) source of interest income. On the opposite side, when rates go up, the bond you bought last Thursday loses value — but only in so far as what people would pay to take it off your hands in a higher-interest-rate environment. If your plan was to hold the bond to maturity, what you’ve lost is the opportunity to have the money invested in that bond earn more at the current higher rates.
Changes in interest rates don’t affect all bonds equally. Long-term bonds experience greater price volatility than short-term bonds. Since the fluctuations will be greater, investors expect to be compensated for taking the extra risk.
There is a direct link between maturity and yield. It can best be seen by drawing a line between the yields available on like securities of different maturities, from shortest to longest. You’re looking at a yield curve.
A consistently increasing spread between the one-year term and the five-year term reflects a very stable market with a likelihood of increasing rates. In financial lingo this is referred to as a normal yield curve. With a normal yield curve, the longer the term, the higher the rate of interest earned. Sometimes the economy goes through periods when long-term rates are lower than short-term rates, referred to as an inverted yield curve. Then you have to decide whether to take a shorter term at a higher rate and run the risk that rates will be lower when it’s time to renew, or choose a longer term at a lower rate at which point you hope rates will have risen. An inverted yield curve is sometimes considered to be a harbinger of recession. When interest rates remain the same regardless of the amount of time that the money is invested, the yield curve is referred to as being flat. In a flat interest-rate environment, the reward for choosing a long-term maturity is relatively small so investors tend to stay in the short end of the maturity range.
By watching the yield curve, which is reported in the financial press, you’ll get a sense of where the market believes interest rates are headed, an important factor that could affect your bonds’ prices.
Bonds also suffer from credit risk — the risk that the bond issuer won’t come through with the interest payments or will default completely on the bond so you’ll lose your capital too. The trade-off when assessing credit risk is that a lower quality or junk bond (such as one offered by a company in financial trouble or in countries that can’t borrow from anybody else because they’ve used up their good will or their debt service) must offer a higher yield than a bond of superior quality. And this must be measured against the likelihood that this higher yielding bond exposes you to a greater risk of default.
The ideal time to be a long-bond investor is during periods of falling interest rates. When interest rates are rising, stick with short-term bonds in order to maximize capital preservation and to reinvest more quickly as rates move higher.
A key determinant of bond price movements is inflation. And that’s not just the Bank of Canada’s perception of inflation, but also investors’ perceptions and, therefore, their demand. When inflationary fears strike, bond prices fall to increase yields enough to entice new bond buyers to accept this potential risk.
Some people in the biz believe that because gold has historically been considered a hedge against inflation, monitoring changes in gold-stock prices can give you an insight into where inflation, and therefore bond prices, are going. A gold mining index such as Barron’s GMI can be both a good indicator for stock investment purposes and for bond prices.
Just as investment diversification is important to equity investing, so too does it play a role in choosing the quality, type and term of the bonds in your portfolio. Remember, diversification helps to protect your portfolio from the ravages in the market — whether the market is in equities or fixed-income securities. Investment-grade bonds, which have lower yields, will offset the potential credit risk on high-yield bonds. Balancing corporate issues with government issues is another way to diversify.
You should also buy securities of various maturities. Buying bonds with a range of maturities, referred to as laddering, reduces your portfolio’s sensitivity to interest rate risk. Invest only in short-term securities and while you’ll have a high degree of stability, you’ll be sacrificing yield. Invest only in long-term securities and your portfolio will be far more volatile, exposing you to losses should you have to sell before maturity.
To ladder your bond portfolio, buy an assortment of bonds with maturities distributed over time — equal amounts in bonds maturing in two, four, six, eight and 10 years. When the first bonds mature, reinvest the money in a 10-year maturity to maintain the ladder.
Next week: Equity Investing
Last week: Types of Bonds
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Sticky Situation:
This in from S: My partner does not fully support the “getting out of debt” plan. He says he does but then really doesn’t embrace it. We have no joint debt however we do have our own from our past lives. We also have a joint bank account for “joint expenses”. I am just starting this journey and am quite able to do it on my own, but how do you deal with this situation effectively while contributing jointly?
July 27, 2010 at 7:08 am
I take it by your use of the word “partner” you are not legally wed. Thankfully you have no joint debt. You need to have an understanding (written if you need it to be) that a predetermined amount must be deposited into the joint expenses account to cover the joint bills, which I’m guessing are rent, utilities, and the like, with a little extra to cover any unexpected rate hikes and so you avoid those nasty overdraft fees.
You then come up with your own debt repayment plan for your debt, go over it with your partner so they understand what your life is going to look like for the next while, and get payin’. Lovey can just muddle along on his/her own and keep wading around in the slop for however long. But make sure your partner is crystal clear on one thing: Not one thin dime will be lent; no co-signing on a loan because their credit rating stinks; no “little extra” will be chipped in for joint activities because someone is “a little short right now,” and you are not going to be swayed into spending more than you’ve allotted for variable expenses so you won’t be hopping on a plane to Cancun for a while.
It may cause a rift, it may cause a split, it may cause Lovey to get with the program, but you do deserve your chance to be planted on terra firma.
July 27, 2010 at 7:19 am
For S and the sticky situation: I think I’ve been in a similar spot where you are now. A few years ago, I cohabitated with and purchased a home with a fella. We even had a cohabitation agreement prepared by his lawyer and mine (at my insistence) prior to moving in.
I was previously divorced with two kids, he came with no previous relationship or kids.
We shared the household expenses 50/50 – which was seemingly a good deal for me because I earned more than he did, and I also brought one kid into our household who added to the demand on groceries, electricity, water, etc.
What became apparent to me as the relationship drew on, was this: despite our sharing of the joint expenses – we lived two distinct financial lives. I also had the responsibility for the children, their clothing, extra-curricular activities, hair cuts, school fees, transportation (public transit), etc. While he tried to help, there was still a great economic divide. We were together in the home, but I was alone in my parenting and the responsibilities that came with that.
As a result, my debt grew. Now, that relationship is over and despite my accumulation of more debt in order to get out of the relationship, I’m well on my way to being consumer debt free.
If in your relationship you’re alone in your goals and responsibility, there will be a growing stress between you. It sounds like you’ve discussed it already, and (s)he’s not fully on board. I would suggest discussing it again and being crystal clear about how important this is to you, and outlining your plan for going where you want to go, and what (s)he needs to do to help you arrive there. Stress that you need their support and commitment.
If you don’t get it, my experience says eventually things will get difficult. Good luck to you.
July 27, 2010 at 7:29 am
after being on my ‘get out of debt’ program for awhile (all student debt), i invited my not-so-inclined-to-think-about-finances partner to come with me on my visit to the bank to talk about investments. he wasn’t coming to give advice, but as a ’support’ – in reality, the reason I wanted him to come was because I thought it would be better for him to hear about finances from someone other than me.
I remember learning from watching my parents navigate their relationship that partners often have a hard time learning from each other (maybe it’s a pride thing, maybe they see their partners as equally wise and equally ignorant on the same subjects as them… I dunno). That’s why I’m sure some couples bring in Gail – to show their partner where things are going wrong because their partner won’t listen to them. So, I figure that having someone who’s not you to offer a reminder about why it’s important to look after finances (ESPECIALLY when your life is gonna be affected if you live with this person forever) could be helpful. AND, this third party is talking about your finances, so your partner doesn’t feel attacked. After that, give him some time, and approach him again to see how he feels.
July 27, 2010 at 7:46 am
I agree with your 2 previous posters – yet ‘think’ when Maryl wrote:
‘I take it by your use of the word “partner” you are not legally wed. Thankfully you have no joint debt.’
…that may be inaccurate. If I understand correctly, according to the eyes of the law, if you cohabit with your common law partner for 3 + yrs, then half is his/hers and the other half is yours (including combined debt). I could be wrong – but this is what I think is the case. If there are other readers out there who have more up to date and accurate knowledge in this regards – please share away. Thanks.
July 27, 2010 at 8:34 am
Re: Sticky
S states “he does not fully support, he says he does and then but then really doesn’t embrace it”. It depends upon how much support, and not fully embracing it refers to. There are levels of financial budget ability, and also some people can take things to the extreme.
If he is trully wasteful, buying lunch or dinner frequently, frivulous expenses – items he doesn’t use etc… then’s he not being supportive and probably also quietly using passive aggressive techniques in regards to it.
If he is being wastefuly in small things, that add up to a lot, like buying coffee daily or something like that – probably the easiest way is to point out what those things add up to in a year, and what they equal.
Also, if S looks at her/his budget, do they have all of the right percentages in their “categories”, and are they on-track for being out of debt etc? Maybe what he is purchasing isn’t that bad, just not what S would like money spent on.
I would tell S to seriously look at how reasonable the purchases are, and then (in like in an episode of TDDUP), either accept her/him or figure out an “out” plan.
July 27, 2010 at 9:16 am
Ugh, with two marriages gone, I can only tell you what I should have done. If they aren’t on board with where you need to go, get out quick. I know it is possible that someone might wake up and smell the coffee, but I haven’t had good luck that way. Be brutally clear, if you can’t get it worked out now, the odds aren’t good that it will work itself out eventually.
Don’t give up your principles for “love”.
July 27, 2010 at 9:23 am
I think if S is determined to get out debt, even without the full support of her partner, she should go ahead and prepare her budget, making sure to include their half of the joint expenses so the partner doesn’t feel S isn’t contributing during the get out of debt process. S should also make sure his/her partner is aware of the plan and understands why frequent dinners out or other costly forms of entertainment need to be curbed. S could proactively come up with ideas for cheaper date nights (a la TDDUP challenges) and maybe his/her partner will eventually see the light.
Also, regarding the bond posts…
Gail, what’s your opinion on Canada Savings Bonds in comparison to corporate bonds?
July 27, 2010 at 9:37 am
Re:Sticky Situation. S, you’re going in the right direction. Make sure you protect yourself and keep your finances separate except for the joint account. Accept no excuses for failure to contribute the full amount due into that account. Do not get joint credit cards, cell phone plans, car loans, etc. Keep all receipts for major purchases that you make on your own as well as any from the joint account.
Continue to pay off your debt as quickly as possible. Get legal advise on how to protect your property, investments, pension contributions, etc. when in a “common law” situation.
July 27, 2010 at 10:26 am
Good point, Doreen. I live in the U.S. so I don’t have familiarity with what Canada’s domestic partner policies are. Or, actually, those in the U.S. either, because I don’t live with anyone except my daughter, and don’t have a plan to at any time in the near future. I don’t think my state recognizes common-law marriages, if I recall correctly.
July 27, 2010 at 11:48 am
S,
Don’t take on any debt with him. Take care of your own, continue on your path to becoming debt-free and boost your savings. If this is an issue now, it will continue to be one if you get married (I’m assuming you’re not since you used “partner). Save yourself.
July 27, 2010 at 2:06 pm
I echo Maryl’s point of view. The only thing I would add is that joint expenses be assigned by a % of each persons wage. Ergo if one makes more than the other – they pay more of the joint expenses.
July 27, 2010 at 2:31 pm
I have recently married my husband after living together for 9 yrs, and althought we are totally on the same page in regards to finances I still do not believe in blending individual debt (if the partner offers to help fine). He makes considerably more than I do, but I am responsible for my half of all joint expenses and all of my personal expenses, vehicle, health, credit cards (pd in full monthly). I don’t see why S necessarily has to run for the hills because the partner may not be on board. Communicate what you are doing, the money availble for “fun” and that you won’t be swayed from your path. If the partner wants to do something S can’t afford, then he can ante up S’s share as well if its something he truly wants them to do. I do agree that she should no co-sign or do joint loans etc if they are in agreement of payment terms.
July 27, 2010 at 3:57 pm
Sticky Situation:
The common law rules different for each province. It is important to get legal advice in case stuff happens. In some places, they want to the split to be quick without long term support. Check if your savings will be better sheltered (legally) in an RSP instead of TFSA or regular savings. Ins omeprovinces you are either married or you are not.
Some people wake up once they see the progress the other one makes. You have to decide how you time you are willing to gamble in the relationship.
Stick to your plan and let you partner be aware of your goal and the reasons behind your budget. Don’t leave your partner out of the loop. Discuss your common goals and the path to reaching those goals.
July 27, 2010 at 8:02 pm
It is true that the Family Law Act differs from one province to the next. The best thing to do is draw up a cohabitation agreement (and a WILL)
to establish what assets and which debts are yours and which belong to your partner. I could be wrong but I don’t think that any province has a 50/50 law. That would be for marriage. There are many assumptions and falsehoods regarding a common-law relationship; it is extremely important that if you are in this situation, you get some legal advice. There are a lot of ‘free’ places in which to find these things out and if you had to pay for some legal advice, it could be the best money you every spent.
July 27, 2010 at 9:08 pm
Jessie, you are a wise woman.
July 29, 2010 at 7:03 am
[...] finances as a couple, personal finance, sharing the bills. Leave a Comment Earlier this week, Gail Vaz-Oxlade posted a sticky situation from one of her readers. While the situation wasn’t exactly unique, it did get me thinking [...]