WEALTH Matters — SUMMER 2010

Investing in bonds

When stock markets have high volatility as they have recently, many investors seek the safety of cash deposits, GICs and bonds. High interest savings deposits are currently paying up to 0.85% daily interest, and are fully cashable anytime, but these deposits always pay much less than even a short term GIC. The top 1-year GIC rate is currently 1.7%.

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Bond prices vary before maturity because they are traded in an active market. Bond prices move in the opposite direction to interest rates, so when interest rates decline as they have in the past two years, bond prices move up. The historical returns include this effect. For investors in a balanced portfolio, these gains offset some of the declines we’ve had in stock markets. But interest rates are very low now, and are starting to increase in some markets, which would depress bond prices. The longer the term of the bond, the greater this effect. Despite this, there is still merit in holding bonds as a defensive part of an overall portfolio. Also, not all bonds are created equal, and some have prospects for better returns than others going forward.

The bond market has always provided an alternative to GICs, and bonds have in the past two years produced some impressive returns. With GIC interest rates as low as they are, we are seeing renewed interest in bond portfolios and funds, but we are concerned about unrealistic expectations that the bond market returns will continue to be as strong as they have recently.

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Investment Market COMMENTARY

INterest rate UPDATE

investing in Bonds

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It is important to note that although both bonds and GICs guarantee principal at maturity and interest payments along the way, there is always the risk of default – when the issuer becomes unable to pay the interest or repay the principal. In the case of GICs, most are covered by Canada Deposit Insurance Corporation, or other deposit insurance regimes for credit unions and life insurance companies. But in the case of bonds, there is no such protection. If the issuer becomes insolvent, interest payments could be suspended and if the issuer becomes bankrupt, you may receive less than 100% of your principal at maturity.

It is generally assumed that government bonds have no risk of default because governments can always raise taxes to pay their bondholders. But as we have seen recently with Greece and Italy, this assumption of security depends on which government is issuing the bonds, and their financial position. Canadian government bonds could be considered very low risk because of Canada’s excellent financial condition. But this also means Canadian government bonds pay very little interest. At the end of June 2010, Canadian government bonds with 5-10 years to maturity were yielding only 3%, which is less than a 5 year GIC, and has not yet factored in the cost of managing the bond portfolio. So if complete guarantees are what you seek, GICs fit this best. .

Corporate bonds offer higher interest rates because their security depends fully on the financial health of the issuing company now and in the future. Large stable companies don’t pay much more than government bonds, but many corporate bonds have interest yields of 5 or 6% and higher. Some bonds that are inflation linked, or floating rate, will increase their interest rates as inflation increases, providing protection against rising market interest rates and the erosive effect of inflation. Having a knowledgeable and experienced bond portfolio manager allows you to hold a portfolio of different types of bonds to maintain a suitable balance between safety and expected return as the economic environment changes.

Many bond funds include high quality income trusts and preferred shares to improve the yield and tax efficiency of the portfolio. Some even convert their interest income into distributions that are taxed as capital gains, cutting the tax rate in half. (see the table below). This can be very attractive for investors in higher tax brackets.

 

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DEX Universe Bond Index

2006

2007

2008

2009

2010 Jun 30

Calendar Year Return

4.0%

3.7%

6.5%

5.4%

3.12%

 

GICs

Bonds

Interest Rate

Guaranteed

Guaranteed

Principal

Guaranteed at maturity

Guaranteed at maturity

Statement Value

Principal + accrued interest

Value of last trade in the market

Market Value

None – most can’t be cashed early

Varies with market interest rates

Net Return Per Tax Bracket

21% Tax Bracket

34% Tax Bracket

46% Tax Bracket

4% interest income

3.18%

2.64%

2.16%

4% capital gains

3.68%

3.32%

3.08%

Advantage of Capital Gains

0.50% (16% higher)

0.78% (26% higher)

0.92% (43% higher)