Investing
Enduring Bonds
Investing in bonds and bond funds has been profitable during the recent market downturn, but will this bubble burst?
FROM:
JAN-FEB 2003 ISSUE | BY
LARRY SHORT
Since March 2000, stock markets around the world have experienced the third worst fall in history. However, while stocks have fallen,
three investment areas have risen dramatically in value.
The first is
gold, which I covered in the
September-October2002 issue. The second is
real estate, which I discussed in
November-December. The third investment area that has done well recently is the bond market. Bonds and bond funds have posted terrific returns since the market downturn.
But, as discussed with the other two areas, can you expect bond market returns to continue to rise? Or is this another bubble about to burst?
When considering whether this area is still a good place to invest, first consider your own or your client's bond knowledge. According to a study prepared for Toronto-based financial planning firm
Cartier Partners and published in the
National Postlast September,
66 per cent of Canadians failed a basic financial literacy exam, and
46 per cent did not understand how bond funds worked. Your clients may be among these financially illiterate, so here's a basic explanation to help you clear up a few misconceptions.
Bonds vs. GICs
A bond is essentially a contract to receive interest, as is a guaranteed investment certificate (GIC). In both cases you make a deposit to purchase the investment and agree to keep your money invested for a specified term, and, in return, you receive the specified payments.
But there are some important differences between a bond and a GIC. The maximum term on a GIC is generally up to
five years, although there are occasionally
seven-year terms. The maximum term on a bond can go up to and beyond
30 years, depending on the issuer.
In addition, you are locked into a GIC. You must hold it until it matures and can't sell it early without losing all of the interest to date. There are cashable GICs, but they penalize you with a much lower interest rate.
You can hold a bond to maturity if you choose, but you also have a
cash-in option, which is not available on a GIC. You can always sell a bond early, and its price is subject to what the market is willing to pay. For example, suppose that the
30-year interest rate level is
five per cent when you decide to invest $100 in a bond. You would use your $100 to buy a bond and receive
$5 per year in interest for
30 years. You will always receive that
$5 per year for
30 years, and at the end of 30 years you get your initial $100 back.
But, what happens if, at the end of the
first year, interest rates rise to
10 per cent? The price of the bond will fall until the
$5 interest payment yields
10 per cent of the price of the bond. Remember the
$5 payment is constant. So the price of the bond will decrease to approximately $50 to make the
$5 interest payment equal to
10 per cent. If you want to sell it, you will get approximately $50 for every
$100 bond you had invested in.
Essentially, if the market rates rise after you buy a bond, you will suffer a loss. In this example, you will have tied your money to earning five per cent when alternative investments offer higher returns. This is reflected in a capital loss on the
bond — a fall in its market price. The longer your money is tied up, the greater the loss and, correspondingly, the greater the drop in the bond price. If you hold to maturity you will still get your $100 back, but if you sell before maturity with the bond price down, you will get less than the purchase price.
Bonds vs. Bond Funds
You can buy actual bonds or you can invest in them through a bond fund. A bond fund is a mutual fund that invests only in bonds. A knowledgeable and experienced fund manager will manage your bonds for you for a fee of usually one to two per cent. Fund managers will buy and sell according to what they expect in the marketplace, so you get professional management and theoretically higher rates of return than if you did it yourself.
And, after the fees have been paid, some of these funds have done great in the last three years. The
top 50 bond funds in Canada have all gained more than
6.41 per cent per year for the last three years, while the stock markets have plunged. The
top-performing fund has gained
9.8 per cent per year for the last three years after charging a fee of
1.54 per cent per year.
So are bond funds the ideal place to put your money?
Here are the primary factors to consider. A bond fund has no specific maturity date, like a bond does. The managers buy and sell various bonds, all with different maturity dates. In addition, each bond in a bond fund has a different interest rate; you can't determine a specific bond fund's interest rate because it changes so frequently.
In order to try to cope with this, some advisers compute the average term to maturity and the average interest rate of the bonds held in the fund, but these are not really good indicators of what the fund's future holds. And many advisers and investors use the average rate of return that the fund has earned in the last
five years, which is very dangerous indeed.
When interest rates fall, bonds rise, meaning bond funds will also rise. Consequently, if interest rates have been falling for some time, then bond fund returns are going to look great. But does this mean that
next year's returns will also look good? They will if interest rates keep falling. But what if they don't?
Bond Fund Risks
If interest rates rise, bond fund rates of return turn downwards. The risk is that these funds look
best — their three- and
five-year returns look great — after having several good years like they have just gone through. They are at or near
all-time highs. But this may also be an indicator of when these funds are most likely to fall.
Interest rates rise when the stock market rises. In a falling stock market, investors will sell stocks and buy bonds, thus driving up bond prices. The opposite also
occurs — in a rising stock market, investors sell their bonds and bond funds to buy stocks, therefore driving bond prices downward. Currently, the stock markets have been declining for nearly three years. If at some point they change direction, bond fund holders will be hurt.
But what about those who own actual bonds? They won't suffer if they hold onto their bonds to maturity. Their investments may actually outperform bond funds in the short term because they do not have to incur the annual management fee.
Interest in Bonds
There are many very good reasons to hold bond funds as part of your
long-term investment strategy, but it is important to understand how changes in interest rates affect them. Investors should always discuss this with a professional financial adviser, while also investigating whether they should hold bonds instead of bond funds.
And, remember, interest in bonds will not wane as long as the stock market experiences the occasional turmoil. Essentially, they will endure over time. But be careful to buy low, as you would with any stocks.
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Larry Short, B.Comm., CIM, CFP, FCSI, CGA, is a Senior Investment Adviser with TD Waterhouse Investment Advice* in St. John's and is author of In Short: Secrets to Make Your Dollars Grow.