Bonds offer safe haven, but learn the ropes before you jump in
Q – With the stock market plunging, I have been looking to invest in something a bit safer. So I’ve been considering either bonds or bonds funds. What are the risks of investing in bonds? – Asked by R.S.
All investments, including bonds, offer a balance between risk and return. The risk is simply the chance that you will lose some or all of the money you invested. The return is the money you stand to make on the investment. But there is no free lunch: The more risk, the higher the return; the less risk, the lower the return.
Bonds are characterized as fixed-income investments, which typically carry lower risk than an investment in equities. When you purchase a bond, you are promised the return of the face value or the amount you originally invested at the maturity date of the bond. The bond pays you an annual interest rate, known as the “coupon rate.”
There are many types of bonds available, from government bonds to high-yielding corporate “junk” bonds, and each carries different types of risks. Some risks associated with bonds include interest rate risk, reinvestment risk, inflation risk, default risk, and credit rating risk. It is important that you understand each of these risks before investing in the bond market.
When you are comfortable with the associated risk, be sure to buy bonds that have been rated AAA or AA by one of the big bond rating agencies. If safety of capital is your ultimate goal, then stick to federal government-issued bonds, or “Canadas,” and bonds issued by Crown corporations. (Note that Canada Savings Bonds are not “bonds” in the true sense, as they cannot be traded on the open market. In this respect, they are more like liquid term deposits.).
Pure bond funds, such as those found primarily in the Canadian Fixed Income, Canadian Long Term Fixed Income, Canadian Short-Term Fixed Income, Global Fixed Income, and High Yield Fixed Income categories offer a wide range of risk levels, maturities, and yields. Some are actively managed, while others, like exchange-traded funds, passively track indexes.
One advantage of a bond fund is that it’s economical. You get exposure to a range of bonds of your choice while taking advantage of the economies of scale that funds can offer on trading costs – it’s impossible for individual retail investors to get a favorable spread (dealer commission and fees) from a bond dealer on smaller bond purchases. Bond funds trade in tens or hundreds of millions of dollars in face value every day and are thus able to get far better rates from dealers than individual investors. Exchange-traded funds (ETFs) generally also have lower management expense ratios (MERs) than conventional bond mutual funds.
I strongly believe that bonds should play a role in virtually every investor’s portfolio. And most of us will use bond funds of some sort to get that exposure. But because of the interplay between coupon rate, price, and yield, bonds can be complex investments, especially if you are considering risk-reduction strategies such as laddering (purchasing bond investments with staggered maturity dates). Consult a financial advisor with strategic investment experience to advice you on the best ways to incorporate fixed-income investments into your portfolio.
© 2014 by Robyn K. Thompson. All rights reserved. Reproduction without permission is prohibited.