“Fixed income” investment vehicles, like bonds, term deposits, GICs and strip bonds, typically form the “bedrock” of an investment portfolio.When equity markets “tank”, fixed income holdings shore up the portfolio returns.
We often observe how strong portfolios have a “character”, or sense of cohesion, to them. Poorly constructed portfolios, on the other hand, glaringly display a lack of cohesion. By this, we refer to the sense of strategy that is the product of the individual investments held in the portfolio. In turn, the strategy should be the product of the risk profile and goals of the investor. Too often, we see portfolios that don’t have a strategy inherent in their construction, or one that is fundamentally inconsistent with the needs and risk-taking of the individual.
A bond portfolio is typically a sub-set of the entire portfolio, the size of which depends upon your asset allocation to less risky investments. The bond portfolio, too, displays a character, or cohesion, of its own, which derives from the characteristics of the individual bonds held. You need to be aware of the “issues” in building your bond portfolio:
- Cash requirements
- Capital gains potential
- Credit quality
- Size of portfolio
- Reinvestment risk
- Current yield vs yield to maturity
- Average term to maturity
Cash flow requirements may dictate the overall size of your asset allocation percentage to fixed income. Bonds produce more predictable cash flow than stocks. If you require monthly income, you can buy instruments that pay monthly, like mortgage-backed securities, or you can stagger your semi-annual-pay bond holdings so that any one particular bond is paying in each month of the year. Your cash flow requirements may go beyond the income to the capital itself. For instance, you may need $20,000 in two years to buy a new car, or $5000 each winter for a holiday. In this case, you need to select your bond maturities to have the appropriate amount of capital come due at the selected dates. In the case of RRIFs, the annual payout requirement can be met by having the necessary amount of capital come due in each year.
When we talk about “risk”, what we really mean is the degree of uncertainty in the timing and amount of future cash flows. Bond cash flows are typically more predictable than equity cash flows; however, you can still have a high degree of risk in a bond portfolio, too. Credit quality assesses the degree of risk of the entities that are borrowing your money. Various companies, like the Canadian Bond Rating Service (“CBRS”), assess the quality of borrowers and ascribe a bond rating to each debt issue of those borrowers. These ratings are easily accessible in published books or through an investment advisor. The CBRS ratings, for instance, go from A++ (the highest quality) to D (in default). The lower the rating, the higher the risk, and generally the higher the interest rate to compensate for the risk incurred. “Junk bonds” which became much publicized in the ’80s are simply low rated bonds.
Governments, both federal and provincial, typically are assigned the highest credit ratings, although some provinces whose deficits have run out of control have experienced down-gradings. As many of our governments have eliminated their deficits and, thus, mitigated their need to borrow to finance profligate spending, we are seeing a reduction in the availability of high quality government debt issues. This may force investors to consider issues from other, lower -rated issuers, like corporations.
Reinvestment risk relates to the future rates of return your money will earn and refers to the unpredictability of tomorrow’s interest rates. You no doubt have grappled with this issue in deciding how long to renew your mortgage for. This risk has two components — reinvesting your capital when it matures and reinvesting the periodic interest payments, if you do not need them for personal consumption. Predicting interest rates ranks with predicting share prices. Bond fund managers live or die on this very issue. A well-known strategy for the “safe road” is termed “staggered maturities“, whereby the bonds you buy are layered out so that portions of the portfolio mature periodically over several years. Thus, you will not be heavily victimized by what interest rates are doing at a particular point in time. By reinvesting part of your portfolio every 6-12 months, you will ride across the interest rate fluctuations.
If you so choose, one aspect of reinvestment risk can be eliminated by buying strip bonds. They pay all of the interest at the end; thus, you do not have to reinvest interest payments regularly over the term to maturity. Two calculations help to define the character of your bond portfolio: average-term-to-maturity and duration. The former is the weighted average of the terms-to-maturity of all of your holdings. For instance, if you own two equal size bonds and one matures in one year and the other in two years, the average term-to-maturity is 1 1/2 years.
Duration is a more sophisticated concept and calculation. It is the weighted average of the present values of the cash flows. More plainly, duration recognizes that most bonds return cash flow periodically over the life of the bond in the form of interest payments. In contrast, the average-term-to-maturity statistic only values the principal payout at the end. Thus a 10 year 8% bond has a term-to-maturity of 10 years but, after some number crunching, a duration of approximately 8 years. A strip bond, which has no interest payments, would always have the same duration as term-to-maturity.
As we explained in “Prices and yields“, the value of a bond varies inversely with current interest rates. In other words, when interest rates fall, the value of existing bonds increases. If you sell your bond, you will make a profit because you sold it for more than you bought it. When rates fall dramatically, the capital gains can be substantial and match healthy returns in the stock market. These gains are more dramatic for bonds with longer terms-to-maturity and smaller “coupon” rates (the rate of interest paid each period).
This fact derives two rates of return for a bond: current yield and yield-to-maturity. The latter is determined when you buy the bond, never changes and represents your reward for holding the bond until it matures. The former represents a reward, given the direction of current interest rates, if you chose to sell the bond now. Active trading in a bond portfolio results in a capital gain or loss, which can receive preferential tax treatment outside an RRSP/RRIF. However, you need to know that these tax characteristics may be unusable, e.g. capital losses are no good unless you have other capital gains in your life-time to offset against them.
Lastly, the size of your portfolio also dictates strategy. Your bond portfolio allocation needs to be sufficiently large that you can achieve diversification through direct purchase of bonds. If it is too small, you are better to piggyback the appropriate mutual fund which is large enough to deliver the diversification that you yourself cannot.