Do You Find Bonds A Bit Confusing?

At the end of our  High Rock Weekly Video, I prompt our viewers to send feedback and ask questions, because if one person has a question (and they are always all good questions), it is highly likely that others have the same one. Yesterday I received an excellent question and decided to include it and hopefully some answers that will help anyone else who may have similar desire for knowledge! (warning: this may take more than 1 blog)

"Hi, Good stuff as always.

And I have always been a bit confused by the bond market. Maybe a bond market primer would be of interest as a blog post.

My understanding is that as bond prices rise, yields fall. So rising interest rates mean bond prices are falling. But is that a net gain? If you are buying cheaper bonds but getting lower returns, are you ahead? And then there’s the correlation to equity values. As equities drop, people retreat to the security of bonds? Prices go up but yields come down? Is that a strictly defensive posture? And any bonds you hold, I assume are unaffected. You’ve bought at one price with a fixed yield.

Governments raise interest rates to cool fast-growing economies. 

But the economy seems to be stumbling along at an unspectacular growth rate, despite high stock prices. Is it an anomaly?

I suspect I’m not the only one who finds bonds a bit confusing. "

In case you did not already know, I was a bond trader from the mid 1980's until 1999. Paul has been trading them (and still does) since 1990. So we know our stuff!

If you have  a balanced 60% equity and 40% fixed income you likely have been told that, at least in historical perspective, when stocks go down in price, there will be an offsetting increase in the price of the bonds that you own that will, at least partially, protect your portfolio until stock prices start to rise again. In 2008-2009 for example (obviously an extreme circumstance), stock markets dropped close to 60%, but a 60/40 balanced portfolio dropped about 20% over the same time period. This negative correlation between stocks and bonds was able to reduce the volatility and allow a much quicker period of portfolio recovery: a little over a year for the balanced portfolio compared to multiple years for the stock portfolio.

Back in December, I wrote a blog called "Myth Busting Of The Bonds In Your Portfolio", which I highly recommend having a look at as it does cover some of the basics:

Remember that bonds are issued at $100 per bond at a fixed interest rate for a specified maturity. Usually (and we shall focus on Government of Canada bonds, not to be confused with Canada Savings bonds, as they are the safest) they are issued for a term of 2 years, 5 years, 10 years or 30 years.

For example, recently the Government  of Canada auctioned a 10 year bond (which will mature in June of  2028) with a coupon of 2% (interest paid semi-annually). At the time, the buyers were prepared to pay $100 for this particular bond. If they hold it until it matures, they will get their $100 back, plus  2% annual interest paid to them ($2, $1 paid every 6 months). 

What are the risks?

1) Will the issuer be a able to pay interest and repay the principal (safety)? In this case, that is not a concern (Canada has a AAA rating, the highest).

2) What is the current and expected rate of inflation (increase in cost of living) and will this reduce the value of the bond in the future. If inflation is going to grow at an annual rate of 2% and the bond is going to pay you 2%, then you are going to have a "real" return of 0. But, perhaps that is worth the safety of the bond (compared to other, more risky assets in your portfolio) and provides the desired balance and it is better than sitting in cash which pays 0%.

Nonetheless, fast forward to now and in the secondary market (where bonds are actively trading as buyers and sellers re-position their bond holdings for a myriad of reasons) that particular bond is trading at a price of $96.65 ($3.65 lower than the issue price). The Yield to Maturity (at this discounted price) is now 2.38%. Although the coupon or semi-annual interest rate paid to you is still 2%, the actual return of holding the bond to maturity means that you get an additional $3.65 when the principal of $100 is repaid (if you were to by the bond at the discounted price today).

That means that bond investors are now demanding a better return (to purchase the bond) than at the time the bond was issued (i.e. inflation expectations are rising). If you are a seller, you will take a capital loss (but you will have accrued some interest since you bought the bond, so it reduces the loss slightly. Whatever interest has accrued is paid to you buy the buyer).

If you own that bond in your portfolio, it will be marked to market every day, showing the daily change in the trading price. So, at the moment, your portfolio will show a capital loss on the bond (if you purchased it when it was issued). 

However, until you actually sell that bond, you have an "unrealized" capital loss. If you sell the bond, you have a "realized" capital loss. If you hold the bond to its full maturity, despite all the daily changes in price between now and then, you will break even on the price and have earned the $2 per year in income. So while the day to day swings in price affect the total value of your portfolio on any given day. If you hold the bond until maturity, those daily swings in price don't matter. Unless you sell the bond.

So why do people sell bonds in the secondary market?

1) They fear higher inflation and expect to buy that bond back at a lower price (deeper discount) and higher yield to maturity in the future.

2) They need to raise cash (perhaps to buy cheaper assets: stocks, bonds or other) and this is the most advantageous asset to sell (see number 1).

3) If, as in number 1, inflation is rising, what will be the Bank of Canada's response (i.e. will the Bank of Canada increase its interest rate)?

To be continued!! (I hope the suspense will bring y'all back!!)