Why Do We Own Bonds?

We often discuss having balance in a portfolio as a concept that can and does, at times, prove itself out when we are forced to endure the fallout from extreme shocks to the economy that create enormous amounts of volatility in equity markets.

A cursory glance at our client portfolios with a heavier weight in fixed income securities (bonds) this morning reveals a year to date return somewhere between -4% and -5%, a welcome sight for those who are less tolerant of big swings in their portfolios.

Importantly, some of this portfolio value deterioration is from the downward price adjustment to their bond holdings, which can and may be just illusory and temporary because we know that bonds will mature at a certain date in time and repay the bond holder the original issue value unless, of course, the bond issuer defaults (herein lies one of the risks).

In the interim, the bond pays the bond holder a payment (usually semi-annually) that is the coupon interest rate which is fixed when the bond is issued. Hence the term "fixed" income.

Because bonds do trade in a secondary market, where buyers and sellers for their various reasons (perhaps buyers looking for value in income assets or sellers looking to raise cash) meet to transact at a set price.

That set price may be above or below the issue price, depending on a number of factors:

1) current interest rates

2) the length of time to maturity (duration)

3) inflation expectations

4) issuers credit rating (risk of default)

Let's, for example, say that we bought a bond at issue ($100). The coupon (annual interest payment) was 4% and it matures in 5 years. So, if we hold this bond to maturity, we get annual income of 4%, each year for 5 years. 

Say we bought $10,000 worth. We get semi-annual payments of $200 cash. This is income (and taxed as income FYI).

If, at a future date, because another holder of this same bond gets concerned about interest rates going up (because inflation is creeping higher / economy is getting stronger or the issuer goes from a BBB rating to a BB rating), they may want to sell this bond. If a buyer in the secondary market only wants to pay $90 for the bond and the seller and buyer transact, the buyer is getting a discounted price for the semi-annual $200 guaranteed income stream.

The secondary market buyer gets $400 per year on his investment of $9,000. Simple math for this example, is an annual cash yield of 4.44%.

If there is 4 years left to maturity, the secondary market buyer will get $400 for 4 years = $1600, plus $10,000 at maturity ($1,000 capital gain) for a total return of $11,600 on a $9,000 investment. Simple math (not taking into consideration the reinvestment of the semiannual $200 interest payments) suggests a $2600 total return over 4 years or about 7.2% annualized.

Still with me?

What about our bond that we still hold?

In our portfolios, it is now valued or "marked to market" at the new price: $90. Which would show in our portfolios as $9,000 and an unrealized "loss" of $1,000.

Our "loss", unless we decide to sell (maybe we think we can buy it back at $80-85 sometime in the future?) is not realized if we hold the bond to maturity and the issuer of the bond pays us back in full ($10,000) and we have collected the $200 semi-annual interest payments. 

So what may look like reduced portfolio value after year 1, will end up being mitigated by year 5 (bond's maturity) as long as the issuer does not default (which is a risk that we must always monitor). A good portfolio manager will continually assess the default risk in a bond portfolio. Something that you may not get in an ETF.

Nonetheless, total portfolio value is a combination of the prices of all assets at "mark to market" on a given day: bond prices, stock prices, ETF prices, mutual fund prices, etc.

But, if you have "unrealized" bond losses, but plan to hold the bonds to maturity, you can discount these losses somewhat and the lower portfolio value becomes a bit misleading (as well you are receiving income stream into the future, to the bonds maturity, which is not included in the mark to market).

Remember that the "mark to market" of a portfolio is there to inform you that if you were to sell everything at that point in time (for most long-term investors an unlikely scenario) that would be the cash value you would receive.

Sometimes the safety factors built in to bond ownership are not necessarily completely built into the portfolio value. Especially when there are selling factors for bonds, whereby some investors and traders just need to raise cash at any price, some of which we have seen recently with the economic shock from the  coronavirus.

As markets settle, so will bond prices (as long as issuers are not defaulting) and it helps that the Bank of Canada is buying bonds to give the market needed liquidity.

This is what a client had to say, yesterday:

 I had a feeling something like this was on the horizon but the other guys kept saying there's more growth out there. Our switch to High Rock was timely and saved us some heartache. We're not worried at all and are sleeping well. TE