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Income and Yield

What bond strategy is best for you?

By Andrew Allentuck
Globe Investor Magazine Online, April 9, 2008

It's possible to buy bonds that have the highest yield for any given period until they mature. Other bonds can be bought at deep discounts from their price at maturity and these can generate big capital gains for speculators. It is also possible to buy bonds that tend not to vary too much in price as interest rates rise and fall.

That's not all. Other bonds put all their interest payments at the end and therefore do not force the bond holder to shop for ways to reinvest interest. Finally, there are bonds that pay their interest with an adjustment so that they pace changes in the consumer price index and therefore keep up with inflation.

The bonds are there for the picking. You need to have these strategic goals in mind, for bond investing is a much different process than investing in stocks.

"Investment grade bonds with known and certain returns are a more precise means of investment, while stocks are subject to the volatility of earnings," says Edward Jong, senior vice-president at Mak Allan & Day Capital Partners Inc. and portfolio manager of the FrontierAlt Opportunistic Bond Fund in Toronto.

Let's review the strategies: Bonds for maximum income A bond investor who wants maximum income and plans to hold to the bond's maturity can buy a bond for its current yield. That means shopping for high-coupon bonds. Each investment dealer has an inventory of bonds for sale. Ask for bonds with high coupons.

These days, that could mean a bond that pays interest in the low teens, Mr. Jong notes. For example, there's a Government of Canada 11.25-per-cent bond due June 1, 2015. The bond is priced at $151.31 per hundred, which would ensure a capital loss when the bond matures at $1,000. The investor would take a loss at maturity, but adjusted for the loss, the bond's current return to maturity is 3.18 per cent, which is what the market recently paid on seven-year federal bonds.

For a retired investor who wants to have the most secure income, a high coupon bond can work. When the bond's term is up, there will be a capital loss, but this can be used to reduce capital gains on other trades, Mr. Jong says.

Bonds for maximum compound return An investor who wants the maximum compounded return - that's current yield plus capital gain-should consider yield to maturity. Bond websites and trading screens show yield to maturity.

One thing to look out for is to check if a bond has a call feature, which is common on corporate bonds. It means that at a defined date in the future, the issuer can buy back the bond. The issuer may do that if it wants to cut its debt, or if interest rates fall and the issuer figures that newly issued bonds will have lower rates.

For example, one might find an existing 20-year bond that pays 5.25 per cent a year until maturity in July, 2018. But the bond comes with a call feature - really a risk - that the issuer can redeem it after July, 2008 at a price of $101 per hundred. The issuer has offered a 1-per-cent premium as an inducement to sell the bond. Interest rates this year could fall further and make it decidedly much cheaper to redeem and refinance by selling new bonds. Odds are that in this case, the issuer will call the bond. The investor therefore has to calculate yield by dividing the 5.25 per cent coupon twice-once by the $100 price for a yield of 5.25 per cent and then by the call price, $101, which gives the slightly lower yield of 5.19 per cent. You have to add the value of the premium as well. Bond pricing websites do most of this work for you, so there's no neet to wear out pencils.

Bonds with price stability Investors who want protection against price fluctuations should pick high coupon bonds. The reason - the higher the coupon, the quicker the bond repays its cost and the less chance that changes in interest rates will affect cash flows, Mr. Jong explains.

When comparing two bonds with equal yields to maturity, the investor who wants to minimize the potential drop in the bond's price if interest rates should rise (and also limit his profit if interest rates fall) should pick the bond with the higher coupon. That's because the higher the coupon, the quicker it pays and the less money one has to wait for in future.

But there is also a cost, for the high-coupon bond will have to be bought for more than its redemption price. In other words, if you want to buy a bond with volatility protection, you have to pay for it, Mr. Jong says.

The principle that makes high-coupon bonds less volatile in price than low-coupon bonds is something anyone would understand in a casino. "The more money you have in your pocket, the lower your exposure to changing interest rates on the unpaid coupons," says Dan Bastasic, vice-president of investments for Mackenzie Financial Corp. in Toronto.

An example will show the situation: If there are two investment grade bonds with equal yields, one with a 9-per-cent coupon priced at $130 per hundred and another with a 3-per-cent coupon priced at $95 per hundred of face value, the higher coupon bond will tend to hold its value relatively well.

Should interest rates rise from current levels of about 5.5 per cent on bonds of similar quality to 7.5 per cent, the 9-per-cent bond will drop in price, but by only about 10 per cent. But the low-coupon bond, which is then even further away from current rates, will tend to drop in price to $80. The two losses show the difference: The high coupon bond lost $13/$130 or 10 per cent. The low coupon bond has lost $15/$95 or 16 per cent.

Bonds that maximize capital gains

The investor who wants the strongest price performance from a bond should buy at the biggest possible discount from the redemption price for a given term and quality. The investor is choosing a bond for capital gains rather than income, Mr. Jong adds. For this strategy, the investor can pick a bond that has fallen a great deal in the face of rising interest rates. These days, with interest rates already in a low range, these bonds are hard to find. But for sheer price speculation, the right move would be to buy a bond with a 20- to 30-year lifespan, wait for the bond to mature or interest rates to drop further, then sell at the face value of the bond at maturity.

Bonds without reinvestment risk The investor who wants no reinvestment risk should buy a stripped bond, for there are no coupons to reinvest.

A stripped bond is sold at a price that, at current interest rates, will mature to its face value. For example, a Province of Ontario strip due Jan. 10, 2034, has an interest rate of 4.79 per cent. The bond is currently priced at $29.98 per hundred. That sum, at 4.79 per cent, will become $100 in 26 years. So a $100,000 face value bond would cost $29,980. All the 26 years of interest are already in the bond courtesy of the big discount when it's bought.

But the 26 years of postponed interest make the price of the bond very vulnerable to interest rate changes, for any change in rates up or down magnifies the value of the postponed interest stream. For each 1-per-cent rise in rates, this strip will fall 26 per cent. A conventional bond with the same interest rate that pays semi-annually, as most bonds do, would only lose about 10 per cent of its market price for each 1-per-cent rise in interest rates.

Bonds with no inflation risk The investor who wants a no-worries way to keep up with inflation can buy a Real Return Bond. These bonds tend to be due in 20 to 30 years and they have low coupons, which when boosted by an amount equal to the rate of inflation pace changes in the consumer price index.

Investors, especially pension funds and insurance companies, like these bonds because they can be bought to cover obligations decades hence when beneficiaries retire or insured persons die. The investor can easily compare the yields of maturity of conventional bonds and RRBs to find the implicit interest rate in RRB prices.

For example, inflation is currently running at about 2 per cent in Canada, notes Chris Kresic, senior vice-president for investments at Mackenzie Financial Corp. in Toronto. Long-term RRBs with a 1.65-per-cent coupon get a 2-per-cent boost for inflation adjustment by the Bank of Canada. But that still leaves them paying 3.65 per cent, which is less than the 3.95 per cent available on a conventional bond.

In a sense, that's still a fair deal, he says. "If you believe that there will be unexpected inflation or inflation out of control over the next two or three decades until an RRB matures, the RRB will be a good deal," he explains. "But if you think that once food and fuel prices cool, inflation will subside, then the RRB is not as good a deal as the conventional bond."

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