Six tips for investing in bonds

BY ANDREW ALLENTUCK
Globe Investor Magazine Online, Dec. 6, 2007

The world is having a debt crisis and Canadian capital markets are caught in the middle. Old stalwarts like bank stocks have been knocked down as investors recognize that banks are exposed to billions of dollars worth of risky derivatives. There are few places to hide, but don't forget to consider bonds.

Bond returns have been so low for so long that many investors may have overlooked them. But here are six tips to remember when parking your money in bonds.

1. Learn the alphabet soup of credit rating.

Corporate bonds vary in quality from AAA ultrasafe to single B dubious to C close to default. See www.moodys.com for ratings on 170,000 bonds and other credit instruments. Registration is required, but most of the info is free. For safety, pick the survivors, that is, bonds from companies with strong earnings and manageable debt.

There are bargains these days in senior bonds of major banks. You can pick up a five-year bond from Royal Bank or Bank of Montreal that pays 5 per cent to maturity compared to 3.8 per cent to maturity for a government of Canada bond. There is a theoretical risk that either bank could go up in smoke by 2012, but most investors will take the extra yield boost as a gift.

"It is hard to lose money buying Canadian big five bank bonds; and if you hold them to maturity, you get a great return," says Tom Czitron, who runs fixed income portfolios as a managing director of Sceptre Investment Counsel Ltd. in Toronto.

2. Understand the importance of interest rates.

Government bonds do not default; instead, they fluctuate in response to interest rate changes. Here is how it works. Let's say you have a bond that yields 5 per cent. If interest rates fall to 3 per cent, then the value of your 5-per-cent bond is going to rise. After all, your old bond now has a higher yield compared to new bonds that can only offer 3 per cent.

Conversely, if interest rates rise to 7 per cent, then your 5-per-cent bond will fall in value because no one wants a bond that pays only 5 per cent. The old bond will fall in price until it produces a yield of 7 per cent.

So if you think interest rates are about to fall, it is a good time to buy bonds.

3. Frame the safety you want in terms of the time you need it.

Treasury bills, which are government bonds due in one year or less, are safe but are good for only their time remaining to maturity. If you think that interest rates are headed down, you may want to buy a bond with a longer term. The problem is that very long bonds with terms of 20 to 30 years not only lock in a rate, but can penalize you should interest rates rise.

Rather than speculate on the future course of rates, which even the best economists do not do well, buy bonds for your natural holding period - say the five years before junior will need money for university or the sequence of years when you will be retired.

"You may not be able to predict where interest rates will be in 10 years, but you can predict when you will need money. That makes bond buying a lot simpler," says Craig Allardyce, a fixed income manager at Mavrix Fund Management Inc. in Toronto.

Alternatively, you can build what bond dealers call a "ladder." Say you need a sum of money, perhaps $50,000, in 20 years. What you do is ladder your exposure by dividing up the money into chunks and putting perhaps $10,000 down on a bond due in five years, $10,000 down on a bond due in 10 years, $10,000 down on 15 years and the balance, $20,000 down on the bond with the 20-year maturity.

When each "rung" of the ladder comes due, you reinvest and roll on to the 20-year target.

4. Government bond price changes can be estimated with accuracy.

The amount a bond will gain or lose when interest rates change is called duration. You can calculate duration via the differential equations financial types study in university or look up durations for major federal and most provincial bonds at a website like the Globe and Mail's http://gold.globeinvestor.com. A very short bond has a duration close to zero. Its price will vary little from that based on the interest rate at which it was issued.

On the other hand, a 30-year strip bond that pays no interest until its term is up has a duration of 30; it will rise 30 per cent in value for every 1-per-cent drop in interest rates. With stocks, this kind of precise risk calibration is impossible.

5. Don't be a yield pig.

Be careful with anything that isn't A rated. That's because after you leave the relatively safe world of bonds with various numbers of A's for ratings, default rates soar. Canadian corporate bonds rated single B, which is way below investment grade, have a cumulative 28.3-per-cent default record over 10 years in comparison to AAA Canada corporates that have a zero-per-cent default record over 10 years.

"Low-rated bonds are buyer beware territory; you have to do your homework before you buy," says Chris Kresic, senior vice-president for investments at Mackenzie Financial Corporation in Toronto.

6. Buying bond funds.

If you want to leave the details of bond trading to pros, buy into a bond fund with a manager with a strong track record over at least five years. "Investors who pile into bonds they don't understand can lose badly," Mr. Czitron says.

And pay attention to fees. Bond returns are usually mid-single digits annually. The average management fee on a bond fund, almost 2 per cent a year, can really eat into returns if bond yields are low like they are now.

Also, be aware of what kind of bond fund you're buying. Canadian fixed income funds turned in an average 0.48-per-cent return for the 12 months ended Oct. 31, 2007. But over the 10 years ended Oct. 31, they had an average annual compound return of 4.56 per cent. By comparison, high-yield bond funds paid 0.99-per-cent for the last 12 months but generated an average annual compound return of 3.68 per cent for the decade.

Either way, look for funds with performance justified by fees. You are entitled to get what you pay for.

Special to The Globe and Mail