The Canadian Rational Investor
Brian Beamish FCSI
Fixed Income Investing
Bonds are guaranteed, stocks are not!


Introduction


This is an introductory seminar on fixed income investing strategies for Canadian workers and investors. This information is meant for basic understanding of the general concepts behind fixed income investing and by no means represents a thorough examination. My goal is to try and convey a few of the pieces of market wisdom, with regard to bonds, I have picked up over the past fifteen years. I strongly encourage feedback and hope to hear your questions, as all of these seminars are an ongoing work in progress.

Bonds Defined
Historical Perspective
The Yield Curve
The first part of the seminar is focused on defining the fixed income market. We look at the size of the bond market vs. equity market, what exactly yield is, and how one judges the quality of bonds. Next, we look at the historical performance of the highest quality bond (US Government treasuries) to give us a idea of expectations of interest rates going forward. We then look at the yield curve & what a rising, falling and flat curve means to the economy.
Portfolio Inclusion
We finish this seminar with a few general rules investors should use when it comes to bond investing. These include the percentage of a portfolio that should be made up of bonds, the concept of laddering your portfolio of fixed income assets and lastly, the rule of '72 and how it effects relative investment attractivness.


Bonds Defined

back to top


Have you ever borrowed money? Of course you have! Whether it was hitting our parents up for a few bucks to buy candy or asking the bank for a mortgage, most of us have borrowed money at some point in our life.

Just like people need money, so do companies and governments. A company needs funds to expand into new markets while governments need money for everything from infrastructure to social programs. The problem large organizations run into is that they typically need far more money than the average bank can provide. The solution is to raise money by issuing bonds (or other debt instruments) to a public market. Thousands of investors then each lend a portion of the capital needed.

Really, a bond is nothing more than a loan of which you are the lender. The organization that sells a bond is known as the issuer. You can think of it as an IOU given by a borrower (the issuer) to a lender (the investor).

Of course, nobody would loan their hard-earned money for nothing. The issuer of a bond must pay the investor something extra for the privilege of using his or her money. This "extra" comes in the form of interest payments, which are made at a predetermined rate and schedule. The interest rate is often referred to as the coupon. The date on which the issuer has to repay the amount borrowed, known as face value, is called the maturity date. Bonds are known as fixed-income securities because you know the exact amount of cash you'll get back, provided you hold the security until maturity.

Say for example you buy a bond with a face value of $1000, a coupon of 8%, and a maturity of ten years. This means you'll receive a total of $80 ($1000*8%) of interest per year for the next 10 years. Actually, because most bonds pay interest semi-annually, you'll receive two payments of $40 a year for ten years. When the bond matures after a decade you'll get your $1000 back.

How big is the bond market?


Judging the quality of bonds, one rating service: DBRS

The DBRS long-term debt rating scale is meant to give an indication of the risk that a borrower will not fulfill its full obligations in a timely manner, with respect to both interest and principal commitments. Every DBRS rating is based on quantitative and qualitative considerations relevant to the borrowing entity. Each rating category is denoted by the subcategories “high” and “low”. The absence of either a “high” or “low” designation indicates the rating is in the “middle” of the category. The AAA and D categories do not utilize “high”, “middle”, and “low” as differential grades.

AAA Long-term debt rated AAA is of the highest credit quality, with exceptionally strong protection for the timely repayment of principal and interest. Earnings are considered stable, the structure of the industry in which the entity operates is strong, and the outlook for future profitability is favourable. There are few qualifying factors present that would detract from the performance of the entity. The strength of liquidity and coverage ratios is unquestioned and the entity has established a credible track record of superior performance. Given the extremely high standard that DBRS has set for this category, few entities are able to achieve a AAA rating.

AA Long-term debt rated AA is of superior credit quality, and protection of interest and principal is considered high. In many cases they differ from long-term debt rated AAA only to a small degree. Given the extremely restrictive definition DBRS has for the AAA category, entities rated AA are also considered to be strong credits, typically exemplifying above average strength in key areas of consideration and unlikely to be significantly affected by reasonably foreseeable events.

A Long-term debt rated A is of satisfactory credit quality. Protection of interest and principal is still substantial, but the degree of strength is less than that of AA rated entities. While “A” is a respectable rating, entities in this category are considered to be more susceptible to adverse economic conditions and have greater cyclical tendencies than higher-rated securities.

BBB Long-term debt rated BBB is of adequate credit quality. Protection of interest and principal is considered acceptable, but the entity is fairly susceptible to adverse changes in financial and economic conditions, or there may be other adverse conditions present which reduce the strength of the entity and its rated securities.

BB Long-term debt rated BB is defined to be speculative and non investment-grade, where the degree of protection afforded interest and principal is uncertain, particularly during periods of economic recession. Entities in the BB range typically have limited access to capital markets and additional liquidity support. In many cases, deficiencies in critical mass, diversification, and competitive strength are additional negative considerations.

B Long-term debt rated B is considered highly speculative and there is a reasonably high level of uncertainty as to the ability of the entity to pay interest and principal on a continuing basis in the future, especially in periods of economic recession or industry adversity.

CCC CC C Long-term debt rated in any of these categories is very highly speculative and is in danger of default of interest and principal. The degree of adverse elements present is more severe than long-term debt rated B. Long-term debt rated below B often have features which, if not remedied, may lead to default. In practice, there is little difference between these three categories, with CC and C normally used for lower ranking debt of companies for which the senior debt is rated in the CCC to B range.

D A security rated D implies the issuer has either not met a scheduled payment of interest or principal or that the issuer has made it clear that it will miss such a payment in the near future. In some cases, DBRS may not assign a D rating under a bankruptcy announcement scenario, as allowances for grace periods may exist in the underlying legal documentation. Once assigned, the D rating will continue as long as the missed payment continues to be in arrears, and until such time as the rating is suspended, discontinued, or reinstated by DBRS.

Symbol Credit Quality
AAA Highest
AA Superior
A Satisfactory
BBB Adequate
BB Speculative
B Highly Speculative
CCC Very Highly Speculative
CC Very Highly Speculative
C Very Highly Speculative
D In Arrears


Historical Perspective

back to top


Historical perspective
Before one can fully appreciate a short-term trend change in a benchmark like treasury bonds, one must understand where we sit in relation to how these index's act over long periods of time. Here is a look at US long-term interest rates over the past 200 years and then how rates have acted over the past 50 years:

source: Economagic.com

Are there any conclusions we can draw from this first chart? 1. Only looking at a very long term chart can one see how dramatic the move higher was in interest rates through the 1970's and early 1980's. 2. Based on the past 200 years, interest rates have actually averaged about 4.50% or roughly were we have returned to now. 3. Investors should draw from this study the basic idea that interest rates are not normally as volatile as they have been in the past 50 years and that from a yearly or quarterly perspective, the trend has been down since the early 1980's and continues to be so.


Are there any conclusions we can draw from this second chart? 1. We have just recently returned to the lows in interest rates seen in the 1960's but can still move lower into the range seen in the 1950's. 2. The market went into a virtual panic in the last 1970's sending rates up in an almost parabolic fashion (very indicative of the end of a market move). 3. From a medium term basis, we are now starting to see the beginnings of a bottom in interest rates.

What's happening now
Now that we understand where we sit historically we can now look at the shorter-term picture to gauge where we might be going in the near future. Here is a look at US long-term interest rates (and their corresponding trend channels) over the past seven years:

source: stockcharts.com

source: yahoo.com

source: stockcharts.com

source: futuresource.com

Looking at this shorter-term perspective we can clearly see the deflationary trend channel we have been in for the past decade. Rates fell steadily throughout the 1990's but have tried to turn over the past few years. Indeed, the dramatic change in the US government's balance sheet has taken the wind out of the current deflation trend but it must be noted that we have not broken the seven-year channel yet. Referring back to the 50-year chart, we can clearly see the significant downtrend line in rates that currently sits at about 6%. Should the 6% level be breached (consecutive monthly closes above), inflation will once again be the prevailing trend. There are hints that this will indeed happen (as we will discuss shortly) but it has not happened yet and keep in mind, rates bottomed in the 1950's near 2.5% so there is still plenty of room for them to fall more.


The Yield Curve

back to top


The Yield Curve is a plot of treasury yields across the various maturities at a specific point in time. At the front (left) of the yield curve are T-Bills with maturities of 12, 26 and 52 weeks. In the middle are Treasury Notes with maturities of 2, 5 and 10 years. At the end (right) of the yield curve are Treasury Bonds with maturities of 20 and 30 years. In a normal yield curve, yields rise as the maturities increase. If the yield on shorter maturities is higher than that of longer maturities, then an inverted yield curve exists. An inverted yield curve is a sign of tight money and is bearish for stocks.

Link to current yield curve

Dot.com cycle



Jr. Bush cycle





-- Break --



Portfolio inclusion

back to top


Age Ratio

For stocks or mutual funds one often cited rule is: Subtract your age from 100. The result is the percentage of your total investments which should be devoted to stocks and/or stock mutual funds. The remaining number is the percent of your portfolio that should be allocated between cash and fixed income investments. This simple rule of thumb offers a framework for allocating investments by percentage. To illustrate, for an investor aged 40, the percentages would be:

Stocks 100 - age = 60%
Bonds remaining assets = 40%

So where do you put this remaining 40%? While some of it should always remain in cash, fixed income investments provide stability every portfolio should have to offset volatile equity investments. Fixed income investing can be extremely simple or somewhat more complicated depending upon how aggressive an investor wants to be in managing these funds. Alternatives could include buying Canadian Government bonds, Provincial bonds or corporate bonds and since all fixed income investments are sold on a spread basis, investors should never pay commissions on these purchases.

Laddering

One popular way that investors can help to balance risk and return in a bond portfolio is to use a technique called laddering. Building a laddered portfolio means that you buy a collection of bonds with different maturities spread out over your investment time frame. For instance, in a ten-year laddered portfolio, you might purchase bonds that mature in 1, 2, 3, 4, 5, 6, 7, 8, 9, and 10 years. When the first bond matures in a year, you'd reinvest in a bond that matures in ten years, thereby preserving the ladder (and so on for each year). The rationale behind laddering isn't complicated. When you buy bonds with short-term maturities, you have a high degree of stability -- but because these bonds are not very sensitive to changing interest rates, you have to accept a lower yield. When you buy bonds with long-term maturities, you can receive a higher yield, but you must also accept the risk that the prices of the bonds might change. With a laddered portfolio, you would realize greater returns than from holding only short-term bonds, but with lower risk than holding only long-term bonds. By spreading out the maturities of your portfolio, you get protection from interest rate changes. If rates fell by the time you need to reinvest, you'd have to buy a bond with a lower return, but the rest of your portfolio would be generating above-market returns. If rates increased, you might receive a below-market return on your portfolio, but you could start to take care of that the next time one of your laddered bonds matures.

Rule of '72

This rule of thumb helps investors determine the number of years it will take for your investment to double in value. Simply divide the number 72 by the percentage rate you are earning on your investment. Here are two examples...

1. You lend $1,000 to your friend charging 6% interest. 72 divided by 6 is 12. That makes 12 the number of years it would take for your loan to your friend to double to $2,000 if they did not make any payments.

2. You have a savings account with $500 deposited in it. It earns 4% interest from the bank. 72 divided by 4 is 18. It will take 18 years for your $500 to double to $1,000 if you don't make any deposits.

Remember: 72 divided by the Interest Percentage is the number of years it takes to double.

Applying the Rule of 72 to portfolio management

Determine how many years you will keep your investment before cashing it in. Divide that by the number of years it will take to double each time, the number you figured out above.

Now look at what happens to your money each time it doubles...
$1 ... $2 ... $4 ... $8 ... $16 ... $32 ... $64 ... $128 ...

You can see that it makes a big difference how many times your money doubles. If you can make it double only a few more times by making just slightly better investments, you can end up with many times more money at retirement, or whenever you cash in your investment.

Buying Below Par

One popular strategy for ensuring both a steady income and a gauranteed capital gain is to buy fixed income investments when they are trading below par. Since all fixed income investments mature at the principle they were issued at (know as par) one can lock in a capital gain by purchasing bonds that are trading at less than par and holding them until maturity. This is because the interest payments bonds pay (know as the coupon) are fixed at the time they are issued. The only way for bonds to reflect either rising or falling interest rates is for the principle amount to either be discounted (rising interest rates) or given a premium (falling interest rates).

For example:
Interest rates have been rising steadily for 6 months and the prevailing rate on 5 year bonds is currently 5%. A government of Canada bond that has a coupon of 4% will be discounted to reflect prevailing market rates. An investor buys the bond at 90 and holds onto the investment until the bond matures in 5 years. At maturity the bond is repaid by the Government of Canada at par or 100. The investor just realised a 10% Capital gain while being paid 5% to hold the bond. In other words, the investor realized a 15% return from a bond that paid 5% interest.