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?

Just because a bond has a good rating doesn’t mean that all risk has been eliminated. Bonds are also susceptible to interest-rate risk (as all fixed-income investments are), along with market risk, which refers to the uncertainty about the future price of an investment due to changing economic conditions or unpredictable changes in investor psychology and attitudes. For example, the announcement by the federal government regarding lower-than-expected economic growth is likely to result in a broad decline in bond prices as investors lower their expectations of corporate earnings. Grave illness or assassination of a political figure can affect the general market as well.

Rating agencies will signal that they are considering a rating change by placing the security on “under review”. These ratings are made available through the agencies’ rating desks or through their online ratings access, as well as being well publicized in the financial press.

Since the only time interest-rate-volatility risk is a factor with a bond is when you choose to sell it before maturity, a good way to minimize this risk is to buy bonds with different maturity dates based on your specific needs. Let’s say, for example, that your daughter will be going to college in ten years. This year she could buy a bond that matures in ten years, next year she could invest in a bond that matures in nine years and so on. When it comes time to use the money, all the bonds will have matured. Of course, this only works if you are reasonably sure she won’t need the money earlier.

Another strategy in buying bonds takes advantage of the changes in interest rates. For example, if interest rates are currently at a high and the yield curve is inverted (indicating that all the people in the know expect rates to fall), you might decide to buy a bond now to sell it for a profit later when the rates do fall.

A bond’s price is based on a number of factors including interest rates, supply and demand, credit quality, maturity and tax considerations. Naturally, bonds that are newly issued sell at face value. However, those traded in the secondary market fluctuate in respond to demand and supply, along with changes in interest rates and credit quality. When a bond is selling above its face value, it is said to be selling at a premium. When a bond’s price falls below its face value, it is said to be selling at a discount.

Yield is the return you actually earn on the bond based on the price you paid and the interest payment you receive. A bond’s current yield is the annual return on the dollar amount paid for the bond. It is calculated by dividing the bond’s interest payment by its purchase price. Let’s say a bond was issued at $1000 with an interest rate of 8%, your yield would be 8% (80 ÷ 1000 = 8%). If the value of the bond was lower than the original issue price when you bought it, so you only ended up paying $900 for the bond, your yield would be 8.9% (80 ÷ 900 = 8.9%). So buying a bond at a discount will increase the yield on the bond.

Yield to maturity (or yield to call) is considered more meaningful because it tells you the total return you will receive by holding the bond until it matures (or is called). It also lets you compare bonds with different maturities and coupons. To calculate a bond’s yield to maturity, add the total interest received from your date of purchase until maturity (don’t forget the compounded return) along with any gain or loss (if you purchased the bond at a discount or premium). Yield to call is calculated in much the same way except it assumes that a bond purchased at a premium will be called and that the investor will receive face value back at the call date.

Next week: Bonds Quotes

Last week: Fixed-Income Investments

There are a whack of investments that fall into the fixed-income category: from the lowly savings account, to the not-much-more-esteemed GIC, to bond and mortgage mutual funds to extremely liquid treasury bills, to mortgages and their derivatives, such as mortgage-backed securities, to what may be the most popular of all fixed income investments: bonds, both of the corporate and government variety.

Bonds are a way for an entity – be it the federal, provincial/state or municipal governments, or a corporation – to raise money to do the things they want to do. In essence, they are borrowing money from you and paying you interest.

Most bonds pay a set rate of interest semiannually for the life of the bond, with the principal due at maturity. However some bonds pay a floating rate of interest that adjusts to more accurately reflect prevailing market rates. This rate is periodically reset in line with a base interest-rate index such as the rate paid on treasury bills.

Large corporations have found many ways of designing bonds to attract investors while keeping costs in line. These range from mortgage bonds, which corporations issue when they have adequate fixed assets to be pledged, through to debentures, which companies can issue if their financial rating is high enough to allow them to borrow without pledging any assets. When a company does not possess fixed assets or does not wish to pledge against those assets, but is prepared to pledge securities, collateral trust bonds are issued.

A bond’s maturity refers to the specific future date on which your principal will be repaid. Maturities can range from one day up to 30 years. In some cases, bonds have been issued for terms of up to 100 years. Maturity ranges are often categorized as short-term (up to 4 years) medium-term (5 to 12 years) and long-term (12 years or more). While the maturity period is a good guide as to how long the bond will be outstanding, certain bonds have structures that can substantially change the expected life of the investment. With a “call” provision, the issuer may choose to repay the principal at a specified date before maturity. Not a great feature during periods of falling rates since the issuer may call the bonds and you’ll get stuck reinvesting your money at a lower rate. Conversely, the bond may have a “put” feature that would allow bondholders to demand the issuer repurchase the bond prior to maturity. Great feature if you think you might need the money at a moment’s notice.

Since many bonds do not reach maturity for years, or even decades, credit quality is a very important consideration when choosing a bond. The issuer is responsible for providing details as to its financial soundness and creditworthiness. This information is contained in a document known as an offering document, prospectus or official statement.

Rating agencies assign ratings to bonds when they are issued and monitor developments during the bond’s lifetime. Bonds are rated based on the quality of the bond itself and the credit worthiness of the issuer. Usually the lower the bond’s rating the higher its yield. To attract investors, issuers have to pay a higher rate of interest to compensate for the higher risk.

Bond ratings fall into two main categories and are graded on a scale: investment and high-yield or junk bonds. While not all bonds are rated, you might want to think twice about investing in a bond that hasn’t been. Two of the largest rating agencies are Standard & Poor’s and Moody’s and they rate bonds from Highest Quality to Default.

Next Week: More About Bonds

Last Week: 7 Things to Consider Before You Buy a Mutual Fund

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Have you voted in this week’s poll? It’s all about grocery shopping!

Sticky Situation Question: If someone asks how much you spent on your car, your clothes, or your house, and you think it’s none of her business, how do you handle that situation?

The 2nd Annual Picnic in the Park

Date: Sunday, July 11, 2010 from 10 – 3

Where: High Park, Toronto – Area #3 and shelter – here is a map (Note the different location in the park.)

Rules:

• Zero tolerance alcohol policy
• All waste/recyclables must be placed in appropriate containers – if not available, must remove any waste at own cost
• No amplified music or microphones
• Park in designate parking areas only, no parking on grassy areas
• Sale of food/items not permitted
• Tables, BBQs and parking cannot be guaranteed
• No balloons, decorations or signage permitted
• Gas/propane BBQs only, no charcoal BBQs
• No inflatable games, dunk tanks, generators, tents or tarps
• No outside caterers

Food:  Last time people brought an assortment of foods (apps, mains, desserts) and drinks and it worked out very well. Bring your own dishes and cutlery to minimize waste as we also did last time.

Y’all have been asking for some more sophisticated information and investment knowledge and today I’m starting with Bonds.

Bonds are a way for an entity – the federal government, provincial/state or municipal governments, or corporations – to raise money to do they things they want to do. In essence, they are borrowing money from you, and paying interest, so they have the money to do the things they need to do.

Every bond comes with:

1. A maturity, the date at which the principal will be repaid, which can be anywhere from 3 to 30 years.
2. A par value, which is the face value the bondholder will be paid when the bond matures. This is just the principal amount of the bond and doesn’t include the interest.
3. A coupon rate, which is the interest rate the bond is paying. A $1,000 par value bond with a 6% coupon rate will pay you $60 interest yearly. (It’s called a “coupon” because in the old days investors used to have to take the “coupon” in to get the interest.) Many coupon rates are fixed, so their interest rates don’t fluctuate, kinda like a GIC. Some bonds have variable or floating coupon rates so the interest payments change from period to period based on a predetermined schedule or formula. And some bonds pay no interest at all until maturity.
4. A credit rating, which indicates how likely it is the bond will be repaid. A Triple A (or AAA) rating is the best. Junk bonds have the worst rating, and the highest interest rates because of their risk.

If you buy a bond and hold it to maturity, you will earn the coupon rate on the bond. So if you invest $5,000 for 5 years at 8%, you’ll make $400 in interest. But you don’t have to hold a bond to maturity because other people may want to buy your bond, and you may want out before the maturity date. In that case, you’ll sell your bond. 

Bonds react to changes in interest rates. If you have a 30-year bond paying 9% but new ones are paying only 6%, you’d get a premium price when you sold your bond. If an entity’s credit rating changes after you’ve bought the bond, that could change your bond’s underlying price too.

So if you decide to sell your bond before it matures, you may get more or less than you paid for it depending on a whole bunch of factors. Remember, these factors don’t affect you if you hold your bond to maturity, only if you sell before maturity, at which point you may have a capital gain or loss.

Bonds also respond to demand and supply. As demand increases – as more people want your bond – the price also increases, all other factors being equal. Or if the supply goes down – nobody is issuing bonds with a 10% coupon rate, so you’ve got one of the few last double-digits bonds – the value of your bond will go up.

If you’re going to buy bonds, here’s another term you need to be familiar with: yield to maturity. The YTM tells you the total return you will receive by holding the bond until it matures. YTM equals all the interest payments you will earn, assuming you reinvest your interest payments at the same rate as the current yield on the bond, plus any gain (if you purchased the bond at a discount) or loss (if you purchased the bond at a premium). YTM is useful because it lets you compare bonds with different maturity dates and coupon rates.

Some bonds have special features that can have an impact on their price, the returns you earn, and the bond’s risk level. Some bonds can be called (repaid) early, which would limit your ability to collect the high interest rate you thought you were getting. Some can be converted into shares of the issuing company so if that company’s shares go way up, you can jump on the bandwagon. And some bonds can be extended, so the maturity is deferred from the original term to a later date, which means you won’t get your money back when you thought you would. All these special features are known up front, so you can make an informed decision as to whether or not to buy the bond.

If you’ve never invested in anything other than a GIC before, and you want to spread your wings, bonds may be the place to look. They are reasonably conservative (meaning they carry less risk than, say, a stock) and they’re reasonably easy to understand if you don’t go getting all fancy… the investment world can turn anything into anything else. 

Unless you buy a bond mutual fund or a government issued bond, you’ll need a broker or discount broker to execute the buying and selling (call the “trading”) of the bond. 

Here’s a great way to get familiar with bonds — and any other kind of investment you’re interested in learning about — without the risk:

• pick a bond or two or six that you think you might be interested in buying
• research them on the internet or ask an investment house to send you information
• note the price at which you would purchase them if you bought them today 
• follow them for six months to a year to see how you would have done if you had bought them.

When your comfortable that you know enough about bonds to actually put your money on the table, buy bonds!

Imagine that you’re selling lemonade. It’s a hot day and there’s a big demand for a long, cold glass of you’ve got. You can probably charge two bucks a glass and get away with it. Yup, thirsty people won’t think twice about shelling out for a little lemony relief. And if you’re down to your last glass or two, someone may offer a premium, coughing up an extra fifty cents to grab a glass. So, when supply is low and demand is high, prices jump. Of course, if your next-door-neighbours all decide to set up their own lemonade stands, you’re going to have to practically give it away to get it off your hands. And if the weather suddenly changes, a cold wind blowing the leaves and your customers’ thirst away, nobody is going to pay a red cent for your lemonade.

What’s true for lemonade is also true for money. When there’s more money than stuff to buy, prices go up. When there’s more stuff than money, prices go down. Inflation is the measurement of the changes in prices of all that stuff.

Enter interest rates. The lower the interest rates, the less it costs to borrow so there’s money to buy stuff.

Think of interest rates as the price of money. The central bank is in charge of deciding the cost of money overall, so it is the central bankers who set the interest rate. When central bankers raise interest rates, they make money more expensive and so the demand for it goes down. The less money available to buy stuff, the more pressure there is on prices to come down. That’s why higher interest rates lead to lower inflation.

Of course, if the central banker decides to raise interest rates to fight inflation, that means that the economy is going to slow down. After all, if nobody has the money to buy TVs, then the company that makes TVs is going to make fewer, so they’re going to lay off some TV builders, who then won’t have the money to buy food, never mind TVs. And that’s why the interest rate/inflation dance is such a precarious one.

Whenever there is news about the changes in the central bank rate, most people’s eyes glaze over. We know if rates go up, that’s no good for borrowing. But that’s about all we know.

At the turn of the new century, our central bank, the Bank of Canada, introduced a new system of eight “fixed” or pre-specified dates each year for announcing changes to the official interest rate it uses to implement monetary policy. Since the rates could no longer be changed on any day in response to an economic ill wind, this was seen as a good way of stabilizing interest rates. Central banks in Europe and the U.S. Federal Reserve also use this system. Of course, the central bankers reserved the right to make a change off schedule under extreme circumstances.

The Bank of Canada sets interest rates with the objective of keeping inflation between 1- 3%, with an optimal target of 2%. So when the inflation rate hit 3.1% last July (over July 200&), it was the biggest jump we’d seen since September 2005. Then in August, inflation jumped again by 3.5%. Ooops.

Of course, the central bank’s decision has an impact on our ability to borrow money. And while many a lender has been holding the line – not raising rates – to keep customers coming through the doors, those days are drawing to a close. Expect to see higher interest rates as lenders themselves find money is tight and they must pay more.

When rates go up, it isn’t all bad news. Only the borrowers suffer. The savers jump up and down clapping their hands because their deposits are working that much harder. While, typically, periods of high interest rates are associated with periods of high inflation, as with everything else, things will change again. If interest rates jump way up, you should consider buying investments that will hold those higher rates for as long as possible.

Start your research on various interest-based investments now. Learn about options like mortgage-backed investments (don’t laugh), the various types of bonds, and mutual funds that are based on fixed-income investments. Figure out what TIGRs and STRIPS are. Learn the language of investing — including all the stupid acronyms — so you’re ready to take advantage of what comes next.

We are leaving the age of rampant borrowing. Who knows what age we’re entering next. As with everything else in life, the changes are painful. But the opportunities are great. Get focused. Know what you want. Get educated. Take advantage of what the future holds. Become an OWAP…. an Optimist With A Plan!