Are Bonds A Safe Investment?
Q. With the financial mess that a lot of countries are in (or about to be in) these days I wonder how the experts feel about bonds being a safe investment. Johnson & Johnson, for example, has a better credit rating than the U.S. government. Are bonds still safer than stocks? Gary D.
To retirees, receiving investment income is a prime objective. With the current higher prices of blue chip stocks it’s becoming increasingly difficult to get a decent yield. Bonds have always been a key part of an income-oriented portfolio.
Are Bonds Safe?
The face value of government bonds will always be safe because governments have the power of taxation and they can print more money. Corporate bonds pay a little more because they don’t have that power – so they are inherently riskier – but choosing high-grade bonds (BBB and higher) can reduce that risk.
What is the Risk?
The main risk of bonds is interest rate risk and it’s close cousin, inflation risk. As interest rates increase, a bond portfolio will drop in value. If you need to sell before maturity you may lose money.
You can only be sure you’ll get back the face value of a bond if you don’t buy at a premium and you keep the bond until maturity – then price fluctuations won’t matter.
Related: What Are Real Return Bonds?
Most bonds these days are trading at a premium resulting in a capital loss if held to maturity and a reduction in yield. These losses can only be used to offset capital gains.
- A Government of Canada bond purchased on the secondary market maturing June 1, 2015 with a coupon rate of 11.25% has a purchase price of 121.81 ($10,000 bond will cost you $12,181) and the yield is a measly 1.00%
Inflation erodes the purchasing value of fixed income payments – the longer the term, the higher the inflation risk.
Today’s interest rates really have nowhere to go but up – but when? Experts have been predicting interest rate increases for several years now and the Bank of Canada is staying firm.
- A new issue (April 1/2013) Government of Canada 10 year bond has a coupon rate of 1.5%
You can stick to short to medium terms for a steady income. But since long-term bonds normally (not always) will have a higher coupon rate it may make more sense to ladder your bonds to help reduce the impact of changing interest rates.
- GofC 1 to 3 year bonds have an average yield of 1.01%
- GofC 3 to 5 year bonds have an average yield of 1.2 to 1.24%
- GofC 10 year plus bonds have an average yield of 2.33 to 2.38%
- Corporate 10 year plus bonds have an average yield of 3 to 5+%
If you don’t have the funds or the expertise to build a decent bond portfolio, bond ETFs are a good, low cost, professionally managed alternative.
- iShares DEX Universe Bond Index (XBB) has a weighted average coupon rate of 3.92% and a 12 month yield of 3.22%
- iShares DEX All Corporate Bond (XCB) has an average coupon rate of 4.51% and a rolling 12 month yield of 3.78%
- iShares US Corporate Index Fund has a weighted average coupon of 4.98% and a yield of 3.3%
Conclusion
Bonds can provide a worry-free stream of income. For higher coupon rates buy high quality corporate bonds (or ETFs) and diversify by company, sector and geography.
Related: Canadian Monthly Income Fund Comparison
Now, I’m in no way an expert and these are just my opinions.
What’s your take? Are bonds a safe investment today?
One has to define “safe”. Bondholders get priority over shareholders in a serious problem but are not immune (ever hear of European “haircuts” in the news?) Bonds provide no inflation protection, and will fall in value if and when rates rise again. Generally bonds are paying less than blue chip dividends, and they have no potential for growth.
As with almost all fixed income investments in a low interest rate environment, bonds are almost a guaranteed way to lose vs inflation, and to me seem best for shorter term goals, not my retirement. If I live 30 years into retirement bonds look very frightening indeed.
I’m not sure. ING pays me 2.5% in my regular savings account but when that drops, I might consider bonds. The last time I bought bonds, I think the return was in the double digits! Ah, the good old days…
Hm, is that ING Direct Canada, Rosemary? I get 1.35% in my ING Investment Savings Account (ISA)…
http://ingdirect.ca/en/accounts-rates/ourrates/index.html
@igra – They have a short term promotion right now where you get 2.5% on new deposits from April 1st to June 30th – http://www.ingdirect.ca/en/landingpage/sale/
Ah yes… 🙂 Gotta love those short term promotional rates. 🙂
A reasonable summary. There’s a lot of hidden sophistication in the bond markets, but it probably isn’t of interest to most readers. In general, bond sector ETFs are probably a good idea. Diversification is more important with bonds than it is with stocks, but it’s hard for a typical investor to diversify bonds that have a $10K+ coupon. The chunk size is just too big. So buying individual bonds only makes sense for larger institutions. The little guy should look at ETFs. I wish I had recommendations for Canada, but I don’t.
Great explanation — Thank you. I’ll have to watch to see how bonds perform when stocks go down and visa versa. GIC’s sure aren’t the answer — might as well put the cash under my bed like my old aunt. If for example I put funds in XBB am I really getting 3.22%?
I think Weighted Average Yield to Maturity (YTM) is considered a better measure of what one can expect to get from bond ETF or mutual fund. YTM accounts for both the coupon and the current market price of bonds. The current YTM of XBB is 2.22%.
A five-year GIC ladder at ING Direct has YTM of 1.87% at this time but its value is not going to drop when interest rates rise.
Would it be fair to assume that an ETF with shorter term bonds would be better for someone already retired or who might need their cash sooner than later?
It’s generally recommended to look at weighted average duration of a bond ETF or mutual fund when deciding whether it’s suitable for one’s time horizon (when one will need the money). If one holds bond ETF for at least as long as the duration of the fund there is no risk or loosing any capital. If the money will be needed in, say, 3 years XBB with its weighted average duration of 6.93 years would not be a good choice but XSB with its duration of 2.72 years might. Using a 3-year GIC will even be more predictable (and more tax-efficient in a taxable account) in that case.
The way I see it, with longer life expectancies and correspondingly longer time frames that retirements need to be funded, opting for shorter duration bond ETFs might not necessarily be a requirement. On the other hand, as thefiscallyfit pointed out bonds should be considered in the context of the overall asset allocation in a portfolio. Short term bonds have lower correlation with stocks than longer term bonds so one might choose to keep a slightly larger allocation to stocks in retirement rather than opting for longer term bonds.
(I’m a DIY investor in accumulation phase myself so the above is only my view).
Thanks igra. I am retired and trying to plan 3 three years in advance. We are trying to live off dividends and interest but it requires planning and sometimes nerves of steel — lol. I’m not sure if capital preservation should be so important to us; after all thats why we have saved for all these years.
According to mutual fund Fund Facts documents they are safe.
Interesting post. Bonds have an inverse relationship with interest rates so it should be interesting over the next couple of years in terms of yields. Whether you like or don’t like bonds, the are a necessary part of a portfolio when reducing volatility.
I think the best analogy I can use for bonds is: enjoy the party but stay close to the door 😉
Preferred shares — one step up from bonds on risks, but gigantic tax savings.
I agree with Joe. Dividend paying, tried and true Canadian stocks. I am adding Bank of Nova Scotia to my portfolio this week.
I put quite a bit of money in GIC’s when they were around 3.5%, but now that the interest rates have dropped I am biting the bullet and putting my investments in index funds that have a bond component.
Bonds are not at their finest right now, but
a) some defined contribution pension plans only offer bond funds for the fixed income part of the portfolio (no GICs; no preferred shares; no cash) If retirement is close, keeping all of a DC pension in equity stock market funds could be very risky indeed.
b) in theory bonds are the opposite end of the teeter-totter from stocks. If the market plummets your bonds should increase in value as people flee to them for safety. The sad-but-true part of that is that bonds and bond funds could actually lose money if the markets are very strong. But the strong gains in the stock market will offset the bond losses.
We still have money in bonds, but not as much as we might have if interest rates were different.
Good post. I have have few bonds right now.
Although dividend paying stocks are and will never be bonds, with a diverse portfolio of them, they feel pretty bond-like.
Nothing is fully secure. Common shares by far have outperformed anything else over long periods. My family generally lives into their 90’s. No-brainer if I retire in my 60’s. Bonds would be terrifying. Maybe preferred shares in limited amounts.
It sounds like many view it as an either/or proposition when in reality we all should probably own some combination of stocks and bonds. Adding some bonds to an all-stock portfolio will reduce risk while only marginally decreasing expected return. And in retirement owing some bonds will provide some stability to portfolio and often decrease the likelihood of outliving one’s money.