Investing in bonds

QUESTION: I have read an article that you have written and I would like for you to give me some advice on investing in bonds.

- T. Gordon

PFA: When you invest in a bond, you are really giving a loan to the issuer - whether government or a corporate entity - who commits to pay you interest at a rate which may be fixed or variable, and to repay the principal at a specified future date.

As creditors to the issuer, the bondholder has priority to assets before equity investors when a payout is being made due to liquidation or restructuring of an issuing company. Strictly speaking, assets are pledged to secure a bond issue except in the case of government 'bonds', but the term is used loosely to describe any funded debt issue.

Even when all goes well and the full principal is repaid at maturity, the principal will not have the same purchasing power as it did at the time the investment was made due to inflation.

Some bonds have a call or redemption feature whereby the issuer may redeem them at a specified price or date before the stated maturity date.

Bonds trade on a yield-to-maturity basis (YTM), which takes into consideration the interest earned and the capital gain or loss. A bond that is issued at par - that is, 100 per cent of face value - and matures at par has a yield to maturity that is equal to the coupon or stated interest rate.

If bought above par, the YTM would be less than the coupon rate but greater than it if bought at a discount.

Bond prices move in the opposite direction to the direction of interest rates, meaning that the prices of bonds already in issue move up when interest rates move down.

Bonds bought at par and held to maturity will not cause a capital loss to the investor, but if sold before maturity, generate a capital loss or gain depending on whether interest rates are higher or lower than they were at the time of sale relative to the time of purchase.

Bonds bought at a premium or discount will generate a capital loss, or gain at maturity if they mature at par.

Interest-rate movements

Interest-rate movements have the greatest effect on longer-term bonds with a low coupon rate. They generate the highest capital gain when interest rates decline and the greatest capital loss when interest rates increase. The interest rate effect is at its lowest for high coupon short-term bonds.

The price of a bond on the secondary market is determined by the coupon rate, the level of interest rates in the general economy, the term to maturity, and its credit quality. The price of a variable rate bond tends not to change because its yield tends to approximate current market rates.

But there are risks associated with investing in bonds. Credit risk refers to the issuer not being able to pay on time, or at all. Reinvestment risk refers to the risk of reinvesting coupon payments at a lower rate. Liquidity risk refers to the risk of not being able to sell quickly enough to minimise or prevent a loss. We have already mentioned purchasing power risk and call risk.

Bonds can outperform equities if the stock market is performing poorly, or if the level of interest rates is high. Over the long term, though, equities outperform bonds.Nonetheless, bonds play an important role in diversifying a portfolio. They tend not to lose value to the same degree as equities and provide a certain steady stream of income.

A bond portfolio may itself be diversified by using fixed-rate bonds and variable-rate bonds, for example, and by type, issuer, credit quality, or maturity of the bonds therein.

Bonds are useful for an investment strategy focused on the preservation of capital and provide income to meet programmed cash-flow requirements, short term and long term. They are suitable for persons with a low tolerance for risk.

Bonds are particularly good for persons approaching retirement and in retirement; they should employ the strategy of laddering, by which the maturities are spread out. This reduces the need to sell bonds before they mature to meet cash-flow needs risking a capital loss if interest rates exceed the coupon rate of the bonds

Look for opportunities to save taxes such as from bonds bought at a discount, which generate capital gains, unit trusts that invest in bonds, and bonds accorded tax-free status by the appropriate minister of government.

Buy short-term bonds when interest rates are rising, but long-term when rates seem to have peaked or are set to decline.

Oran A. Hall, a member of the Caribbean Financial Planning Association and principal author of "The Handbook of Personal Financial Planning", offers free counsel and advice on personal financial planning. Email: finviser.jm@gmail.com