Shakespeare's Bonds

The difference between a bond and a bond fund manager is that the bond matures.

- Wall Street joke.

Bonds

Why Buy Bonds?

Bonds are usually introduced into a portfolio to reduce volatility and to provide a source of income. Most portfolios should contain from 25% to 75% bonds, depending on the goals of the investor. Individuals seeking income or who need access to capital within a 5-year time frame should have a significant bond component. The bond fraction of an individual's portfolio usually increases as the person ages. However, retirees with significant pension income can consider the pension to be from a "phantom" bond component, and may hold a higher than normal equity fraction in the remainder of their portfolio if the pension meets most of their cash flow needs.

Bonds are usually held within an RRSP because bond income is fully taxed whereas capital gains and Canadian dividend income are taxed at lower rates.

One way to hold bonds in a portfolio is to set up a bond ladder of staggered maturities. A five-year ladder, for example, would hold bonds of 1-, 2-, 3-, 4-, and 5-year maturities. To continue the ladder, each maturing bond would be used to buy a new five-year bond.

The advantage of a bond ladder is that it gives access to cash at 100 cents on the dollar as each bond matures, regardless of interest rates.

Bonds may be purchased either as coupon bonds or as stripped bonds. These options are discussed below. More detail can be found at The Financial Pipeline bond page.

Bonds with very long maturities have significant price volatility. Because some researchers feel that the extra return with long bonds inadequately rewards investors for that volatility, normal long bonds should be avoided and replaced by Real Return Bonds (see below).

Coupon Bonds

"Coupon bonds" provide a semi-annual interest payment (the "coupon"). Retirees may find it useful to have coupon-paying bonds in their RRSP/RRIF portfolios so that they have another source of cash flow (see "Withdrawal Strategy", below). On the other hand, the interest payments can be a nuisance during asset accumulation, since they may be difficult to reinvest efficiently ("reinvestment risk"). If a "bond ladder" (bonds of increasing maturities) is built within an RRSP using stripped bonds (see below) during asset accumulation, after retirement it may be worthwhile to replace the maturing stripped bonds with coupon bonds.

Coupon bonds have a face value or par value of $100 at maturity, but may trade at values greater or less than $100 before maturity, depending upon prevailing interest rates. If rates go up, the market value of the bond will go down. It is possible for a bond having a low coupon to trade at less than $100 if interest rates are high. [If you own a one-year coupon bond paying 3% and the one-year interest rate is 5% the current market value of the bond is roughly $98: in one year you will get $3 interest from the coupon and receive another $2 in price gain (to $100) for a net return of $5.] Alternatively, a bond with a high coupon may trade at above $100 if rates are low.

Coupon bonds held outside an RRSP may incur either a capital gain or a capital loss when redeemed or sold. The tax is payable in the year the sale or redemption occurs. Because capital gains or losses are included in income in non-registered accounts at 50%, at a constant overall bond yield a capital gain is more advantageous than a capital loss. Consider three bond yielding 5% to maturity in one year: one has a 5% coupon and trades at par ($100), one has a 7% coupon and trades at approximately $102, and one has a 3% coupon and trades at approximately $98. Although the before-tax yields are similar, the 7% bond produces $7 in fully-taxed income and a $2 capital loss, which can only be written off against $1 in capital gains. The 3% bond produces $3 in income and $2 in capital gains, which is included as only $1 in taxable income. Therefore, bonds trading below par have a tax advantage in non-registered accounts. Some bond traders refuse to buy any bond that trades above par value because of the possibility of a capital loss.

The yield to maturity, which always reflects current interest rates (as well at the creditworthiness of the issuer) takes into account both the coupon yield and any gain or loss (see a gummy tutorial).

Bonds are purchased with a commission hidden in the difference between bid and ask prices. This commission varies with the term of the bond (longer-term bonds carry a higher commission), with the size of the transaction (very large transactions - $100,000 or more - can get a better deal), and with the dealer. Investors who don't generate high trading revenues can't expect a good deal on bond prices. For most investors, the commission for a mid- to long-term bond is probably about $1.25 per $100 of face value, shading down to somewhere between $0.25 and $0.50 for a short-term bond.

In determining the cost of the bond, it is conventional to assign one-half of the bid-ask spread to the seller and one-half to the buyer. The rate penalty of a $1.00 bid-ask spread on a coupon bond trading at $100 and nominally yielding 5.00% using this convention is shown below:

Stripped Bonds

"Stripped" bonds are purchased at a discount from the nominal $100 face value and provide $100 on maturity, but no cash flow. For example, a stripped bond yielding 5% annually and maturing in two years would cost about $90.70 per $100. Stripped bonds are often favoured during the asset-accumulation phase, since cash flow isn't required and is often a nuisance because the amounts are too small to conveniently reinvest. The stripped bond therefore carries no "reinvestment risk". However, its market value is more greatly affected by interest rate changes than is the market value of the coupon bond. Again using the convention of assigning one half the bid-ask spread to the purchaser, the effect of various spreads on the yield of stripped bond nominally yielding 5% is shown below:

Stripped bonds have a higher rate penalty (and higher total commission) than do coupon bonds at longer maturities, since a $1.25 spread is higher on a percentage basis for a bond bought at $60 than for one bought at $100 . Stripped bonds are also more volatile than coupon bonds.

Stripped bonds should not be held outside an RRSP because tax will be due on the "notional interest" (an amount calculated based on the pro-rated yield to maturity), even though no actual money has been received. The yield penalty from buying mid-term liquid (i.e. heavily-traded) investment-grade stripped or coupon bonds from a major dealer is about 0.01-0.02% per annum.

Bond Duration

The volatility of a bond (or a bond fund) is measured by its duration, which gives the sensitivity of the bond to interest rate changes. Bond fund durations can be obtained from the fund manager. If a bond or bond fund has a duration of, say, 5 years, the value will drop by 5% if interest rates go up by 1%. Durations are usually classified as short (~2-5 years), medium (6-9 years), or long (>10 years). For individually-held coupon bonds, duration increases with increased term to maturity, but decreases with increased coupon yield (because the coupons can be reinvested at a higher rate). For stripped bonds, duration and maturity are the same.

Corporate Bonds

Corporate bonds are generally considered to be higher risk than government bonds, and offer higher yields depending on the credit rating. Credit ratings are available at DBRS and Standard and Poor's. To access the Standard and Poor's ratings, select Region: Canada from the top navigation bar. Choose the Credit Ratings List under the Fixed Income tab on the menu on the left. Use the filter or the alphabetical settings to find selected companies.

Many corporate bonds have call provisions that allow the issuer to redeem them before maturity. It is important that any purchaser understand these provisions before buying! The following discussion of call provisions was posted to "The Wealthy Boomer" by "nfsnfs" (Norbert Schlenker), and is used with permission:

"A call provision on a bond is an option retained by the issuer to redeem the bond before its stated maturity. As with any option, a call provision has value. Therefore, callable bonds trade at a discount to (alternatively, have higher yields than) similar non-callable bonds. The issuer is likely to exercise the option ("call the bonds") when market interest rates have fallen, leaving the bondholder with cash when reinvestment rates are unfavourable.
In Canada, government bonds are generally non-callable, while corporate issues are callable. This is a general rule. Always check for issue specific provisions.
Call provisions are usually exercisable only when some time has passed after the bond is issued. Often, a call has terms that vary over time. For example, a provision could be "Callable at 102 after 5 years, declining to par in 9 years", which is taken to mean that the issuer may call the bond at 102% of par after 5 years, 101.50 after 6, 101 after 7, 100.50 after 8, and at par after 9 years.
In Canada, a peculiar call provision called a "Canada call" has come into existence. (It was developed by underwriters to assuage the anger of large investors who had seen even stringently drawn call provisions abused by issuers - and upheld by courts.) A Canada call adjusts the call price by reference to current yields in the market, with a floor price of par in most cases. For example, a 10% bond with two years remaining to maturity might be callable, but if two year government of Canadas are yielding 4%, the call price will be something like 112. If two year Canadas yield 8%, the call price would be about 104. Such a provision protects bondholders from call with most yield curve changes.
Since Canada calls were first introduced, in the eyes of investors, even they have been abused by issuers because the reference yield curve is usually Canadas but corporate issuers always pay a premium over those rates. Consequently, most bonds issued with Canada call provisions today have a stated premium, usually in the form of +xx bp [bp = basis points, 0.01%], over the Canada curve. Even this is not complete protection against an early and unfair call, as the premium is usually less than what the issuer would normally pay over Canadas."

Barclays Canada has recently announced a Canadian corportate bond ETF (see Bond ETF section). When this ETF starts trading, it will offer simple corporate-bond diversification.

Treasury Bills

Treasury bills, or T-Bills, are issued by the Government of Canada with maturities of from three months to one year. They function like stripped bonds, and are issued at a discount to the value at maturity. They can readily be sold on the secondary market, and are a useful place to park temporary cash. Most brokerages have investment minima; these can range from $10000 to $30000 or more. Shorter-term notes called Cash Management Bills are also available.

Guaranteed Investment Certificates (GICs)

Guaranteed Investment Certificates (GICs) are a reasonable substitute for short-term (5 year or less) bonds for investors with modest portfolios. Amounts up to $100000 total are guaranteed by the Canada Deposit Insurance Corporation (CDIC) for GICs purchased from federally-regulated institutions (banks and trusts). Provincial guarantees may apply to GICs purchased from credit unions.

A better yield can sometimes be obtained by purchasing GICs from a dealer that is not linked to the offering institution. However, some brokers may not allow other-institution GICs to be consolidated in a self-directed RRSP.

Prospective purchasers of short-term bonds should check GIC rates with their broker before committing to a bond purchase. Minimum size requirements may apply and the best rate is usually reserved for non-cashable GICs, which lock the funds in until maturity.

High-Yield Bonds

High-yield bonds, or "junk bonds", are bonds with poor quality ratings. The yields on these bonds can often be quite high, and investors who investigate the companies carefully can often get a very good return.

The major difficulty with purchasing these bonds is that the overall return is defined by the number of defaults, since a single default can cost several years' positive return. In his book "Fooled by Randomness", Nassim Nicholas Taleb expresses the opinion that the market underestimates the cost of improbable events, and that eventually "junk bond" traders tend to "blow up" - i.e. lose all their profits (and sometimes more). Although this risk may be acceptable for younger bond purchasers, I do not think it is as acceptable for retired investors, who do not have a long enough time horizon to recover from any loss.

Another difficulty with high-yield bonds is that the bid-ask spread is very high. In addition, an investor who wishes to sell a high-yield bond may have difficulty in finding a buyer.

Retired investors who wish to include high-yield bonds in their portfolio should limit the exposure to money they can afford to lose (say, to 10% of the portfolio). Considerable care should be taken in choosing the bonds, and single-company exposure should be limited to 2-3%.

Another option that limits the risk is to use a high-yield bond fund. Unfortunately, the fees associated with these funds devour a significant portion of the excess return.

High-yield bonds are similar to equities in terms of risk, and for asset-allocation purposes should be included in the risky (equity) portion of the portfolio. Risk-averse investors (I am one) may choose to forego this asset class completely. Income-seeking investors may wish to consider income trusts and REITs as an alternative.

Foreign-Currency Bonds

Several Canadian entities, including some provinces, offer bonds denominated in foreign currencies - either the US dollar or Euros. These count as Canadian content in an RRSP, and can be used to increase portfolio diversification. The coupons will be converted to Canadian dollars as soon as they are paid, so the yield will be decreased slightly by currency-conversion charges.

The bonds issued by foreign governments (including the US Government) can be also be held directly in an RRSP.

Several US corporate bonds trade on the New York Stock Exchange or the AMEX. Listings can be found in the Wall Street Journal. However, they are only qualified as RRSP investments if the company's stock is also listed.

Investors wishing U.S. dollar income outside an RRSP should instead consider the U.S. dollar preferreds offered by several Canadian companies.

Bond Exchange-Traded Funds

Barclays Canada currently offers three exchange-traded bond funds, one based on the Scotia Capital Universe Bond Index (stock symbol: XBB, MER 0.3%), one based on the Scotia Capital Universe Short Term Bond Index (stock symbol: XSB, MER 0.25%), and one based on the Scotia Capital Real Return Bond Index (stock symbol: XRB, MER 0.35%). They require a brokerage commission for purchase and sale, and carry a price that will vary with prevalent interest rates. These ETFs have an MER that is significantly lower than that of most bond index funds, and XSB and XBB be desirable for investors who are changing their bond composition infrequently (i.e. neither adding nor withdrawing funds, and thus triggering brokerage fees) and who can tolerate the variation in unit prices. XSB has a significantly lower duration than XBB, and thus is less sensitive to interest rate changes. XRB offers limited diversification, since the Scotia Capital Real Return Bond Index is primarily based on only four bonds. Direct purchase of one or more of the four Government of Canada real-return bonds is a better option for most investors.

Three new bond ETFs from Barclays Canada have recently been announced, covering long-term bonds (XLB), government bonds (XGB), and corporate bonds (XCB). These ETFs should start trading in early 2007.

Barclays U.S. also offers several bond ETFs. Better prices than those available with the U.S. treasury-based ETFs should be obtainable with directly-held government bonds for the same reasons as apply to the Canadian bond ETFs. However, the corporate bond ETF (American Stock Exchange symbol: LQD), the Lehman Aggregate Bond Fund (American Stock Exchange symbol: AGG), or the inflation-protected Lehman TIPS Bond Fund (New York Stock Exchange symbol: TIP; see below for a discussion of real-return bonds), may be suitable for some investors. The Lehman Aggregate Bond Fund provides investors with exposure to the Treasury, investment grade corporate and mortgage sectors of the US taxable bond market, and provides access to the total bond market at a modest price (0.20% MER).

Bond Mutual Funds

The bond markets in Canada and the United States are very large and very efficient, which means that it is difficult or impossible for active management to add significant value to a bond mutual fund by trading. Although a small additional return can be obtained by a fund manager by adding investment-quality corporate bonds to a mix of government bonds, the main way to obtain extra return by adding bonds with a longer term-to-maturity. However, as stated earlier, this extra return is accompanied by significant additional volatility. Unfortunately, unlike individually-held bonds, bond funds do not have a return-of-capital guarantee on maturity. Bond funds or bond ETFs with a duration of greater than five years should be avoided when interest rates are low.

Since relatively little value can be added by active management, and buying individual bonds is simple and cost-effective, bond mutual funds with a management expense of above about 0.5% should be avoided, since the extra expense goes directly to the pockets of the managers.

Low-cost bond index funds are a simple alternative for investors who do not wish to purchase bonds directly.

Real-Return Bonds

A very useful, but relatively unknown, type of bond offered by the Government of Canada is the "Real Return Bond" (RRB). This bond offers a rate of return that is tied to the value of the Consumer Price Index (CPI), and thus is automatically adjusted for inflation. Thus, if the RRB is listed as paying, say, 3.5%, the investor will receive 3.5% plus the change in consumer price index; if inflation is at 2% (the center of the Bank of Canada band), the investor will receive 3.5% + 2%, or 5.5%.

The price adjustment is made by multiplying the nominal price for the bond (usually near $100) by an "index ratio" that adjusts for the change in CPI since the bond was issued. Coupon payments are also multiplied by the bond's index ratio.

Since the index ratio factor is tied to the CPI, it is possible that the investor would receive fewer dollars than were originally invested should there be a period of deflation. Also, unlike the similar US TIPS, the index ratio could fall below 1.00 in an extended period of deflation, so that the bonds would pay less than $100 on maturity. Nevertheless, the investor would not lose money on an inflation-adjusted basis because the dollars received, although fewer in number, would individually purchase more. Also, an extended period of deflation is unlikely.

Although some stripped real-return bonds may be available, the market is very thin. Coupon-paying RRBs, on the other hand, should be available from all major dealers. Although an RRB fund is offered by TD, it has a very high MER. An ETF offered by Barclays has a significantly lower MER than the TD fund, but offers limited diversification. An actively-managed fund with a modest MER is now available from PH&N. Investors who intend to hold the bonds to maturity can obtain significantly better returns by purchasing RRBs directly. The yield penalty for buying RRBs directly from a major dealer is only about 0.005-0.010% per annum.

Since inflation is one of the major concerns of retirees, RRBs are particularly attractive, and should be held in an RRSP. The recent (1-year) RRB yields, provided by the Bank of Canada, are shown below. The Y-axis shows real yields and does not include the inflation component:

Real Return Bond Yields

Many people should consider replacing at least half of the normal Canadian-dollar bonds in their RRSP portfolios with RRBs, since the RRBs act as a different asset class and reduce portfolio volatility. Five RRBs are currently available, maturing in 2021, 2026, 2031, 2036, and 2041. If you think you may need the money for a specific purpose - say, to buy an annuity - pick the one that matures closest to desired time frame. The US equivalent of RRBs are called Treasury Inflation-Protected Securities (TIPS). As indicated above, these can be added to an RRSP, either by purchasing them directly or by purchasing the Barclay's TIPS ETF. A Euro-denominated RRB called the OAT€i is also available.

The U.S. also offers a type of inflation-indexed bond called an "I-bond", in which the taxes due on the inflation adjustment are deferred until the bond is sold. This feature (which is unavailable to Canadians under current tax laws) allows U.S. investors to hold an inflation-indexed bond outside of a retirement account. These investments aren't suitable for Canadian non-registered accounts because taxes would be due yearly on the inflation adjustment.

More facts on RRBs can be found below, including links to academic papers that suggest that a higher portfolio withdrawal rate can be maintained by including RRBs in a portfolio:

Real Return Bonds for Canadian Dummies

Finally, I have written a spreadsheet that allows the RRB index ratios to be calculated for any date from the end of the current month to Dec. 1, 2001. The spreadsheet, in Excel format, is here (right click to save it). If buying or selling a bond, the settlement date (three business days after the current date) should be used to calculate the ratio.