Debt’s embrace

As we count down to the first US rate reduction in ten years (this is a big deal), we gotta talk about bonds. And safe stuff. Why you need some.

First, what’s a bond?

Simply a hunk of debt. Governments or corps issue bonds to raise money. They give an investor interest until the bond matures, when she gets all the money back. The more secure the issuer (like the Government of Canada) the less risk, so the lower the interest paid.

But nobody buys a bond to get interest any more. Yields have been in the ditch since the GFC, when central banks crashed rates and bond yields followed. In fact there are trillions of dollars in bonds around the world paying negative returns. So, bonds are held to (a) offset fluctuations in stocks, since they tend to move in opposite directions and (b) to stabilize a portfolio, reducing volatility so you stop worrying about things you cannot control and drink less.

Now besides paying interest (or not), bonds have prices. The day a bond matures it’s worth $100 for every $100 you paid. If interest rates in general rise before the bond matures, it will be worth less and the price will go down – to maybe $95 – because investors can get a better deal with a new, improved bond which pays more. So the cheaper price compensates. But if rates fall before the bond matures it will be worth more – maybe $105, since a buyer gets the principal plus a higher-than-market return.

Finally, you should know that bond yields and prices are opposites. As yields go down (like we’re seeing now), bond prices go up – old bonds are worth more. When yields rise, bond prices plop. That happened last winter.

How to buy bonds? In an ETF. Some funds contain a mix of federal government bonds of various “durations” (length of time to maturity), while others contain provincial or corporate bonds (which generally pay more). You can also get “junk bond” ETFs which hold the debt of riskier issuers who pay a whole lot more interest.

These days about 20% of a balanced portfolio (40% fixed income and 60% growth assets) should be in bonds. That includes a little hunk of federal debt, with the rest in provincial and corporate bonds. Add 4-5% in a cash equivalent (we use an ultra-short-term bond fund for a higher return and no risk) plus about 15% in preferreds, and that makes up the 40%. The overall yield on that is around 4.6%, with the prefs delivering a dividend tax credit. Sweet.

Unlike GICs, this delivers (a) a better return, (b) less tax, (c) total liquidity and (d) the potential of capital gains from the bonds if rates fall or from the prefs if rates rise. Also (e) when stocks correct money flows out of equities into safer assets, including bonds. So in a balanced portfolio this gives investors a built-in shock absorber – a comfort since most people are busy living their lives instead of watching the shallow, soul-sucking wolverines on BNN.

Of course, all of the above is lost on those who fixate on preserving capital. They want no risk, a guarantee and think 3% is fabulous, even when inflation’s 2.5% and they’re fully taxed on interest. If you already have enough money to finance the rest of your life, GICs or a high-interest savings account might work. You don’t need growth. But that’s not most people.

So GICs with their high-tax profile, lack of liquidity, inadequate returns and inability to deliver a capital gain are a poor choice. The fact 80% of all TFSA money sits in GICs or cash savings says a lot about financial literacy and how emotion dictates finances. No wonder there’s a retirement crisis about to hit. People need to stop thinking with their pants. But won’t.

Once again, here it is. Stick this on the fridge. The GreaterFool credo: the biggest risk is not losing money, but running out of it. Especially if you’re a woman.

Now, Wednesday. The American central bank rate will drop a quarter point. There may be another one (or even two) after that by the time of the US election at the end of 2020. But this doesn’t mean rates are reversing and heading for zero. In fact, the Bank of Canada won’t even react this year. Maybe not in 2020, either. But the bond market has been pushing yields lower for some time. Canadian 5-year bonds have dropped from almost 2.5% to just 1.4% – a massive tumble. As that’s happened, bond prices have increased (I told you why) and so have the values of the ETFs that hold those bonds.

Given we’re in Year Ten of an economic expansion, it’s highly likely a recession could materialize before growth resumes. That’s a year away. Maybe two. Nobody knows. When it happens you can be certain central banks will pull the trigger on rate cuts, flooding the economy with liquidity and trying to stimulate  borrowing and spending. Bond yields will plop. Bond prices will rise. Bond ETFs will gain in value, likely as equity-based funds lose value. As in 2008-9, this will give balanced portfolios resiliency, a shallower dip and a faster recovery. And it will happen as GIC rates again sink to 1%.

So don’t be comin’ round here dissing bonds. Get some.