Bonds

The following should give you a little better grasp on one type of Bond

Bonds aren't for sissies.

They’re for anyone who likes a nice, reliable income stream and enjoys knowing that while their principal may fluctuate a little, it’s guaranteed (by the issuer). And bonds are a good place for some high-and-dry money while you wait for bad things to happen.

More on that last part in a moment. But first, let’s just review the nature of bonds. The typical bond is simply a debt instrument that promises to pay the holder a defined amount at periodic intervals (the “coupon”) and repay the principal at maturity. Bonds are generally issued at par, so they mature at face value and thus guarantee the invested principal. The quality of the “guarantee”, of course, varies with the issuer of the bond. If the Government of Canada tells you that it guarantees your bond, you can effectively view that warranty as absolute. The government has sweeping powers of taxation, you see, so it’s difficult to contrive a scenario in which you’d have to worry about not receiving your interest or principal.

Farther down the food chain, the guarantee on corporate bonds is as good as, well, the corporation issuing the bond. That’s a rather broad range of safety. You have your “AAA”-rated players, and then you have your neighbour Bubba Billy, who wants you to buy Bubba Billy’s High Interest Hot Tub Improvement Bonds, “cuz they’ll pay, fer sure!” [Compliance Disclosure: We don’t know your neighbours, or anyone named Bubba Billy. But if we did, this would not be a comment on the credit quality of any bonds bearing a coincidentally similar name.] So buying corporate bonds is different than buying government bonds of a sovereign nation, since the former requires monitoring the credit risks of holding a company’s debt. As a consequence of the higher risk, corporate bonds generally pay a higher income than government bonds of similar term.

Now, although bonds are safe harbour investments, they still have various risks. For instance, bonds hate both rising inflation and interest rate hikes. (The two are related, of course, since interest rate hikes are used in an attempt to cool the hot economic growth that creates inflation.) Bonds hate rising inflation because they make the purchasing power of both the coupon stream and the maturity value decline. Nothing happens to the actual dollar amounts – it’s just that the dollars don’t buy as much. And bonds hate interest rate hikes because they make the fixed coupon payments that looked good at the old rate look less valuable at the new rate.

So that’s a bit on how they work. There’s lots more to know, of course, and managing bonds can be every bit as complex as managing stocks. All that being said, bonds aren’t just for folks who want to clip coupons, or for those who want a guarantee on their principal. Bonds are a perfectly useful place to park money if you are being opportunistically defensive.

Take, for instance, the threat of H5N1. That’s the nasty strain of avian influenza that’s been making waves globally amongst such agencies as the World Health Organization. The essence of the issue is that global health authorities see H5N1 as a significant threat to global health. I’ll leave it to you to scare yourself silly by doing the reading for yourself (see the WHO website, or just Google H5N1), but it is sufficient to note that lots of folks who work in the disease business say there’s trouble brewing out there. Maybe even spooky Stephen King-novel trouble. That tends to spook the markets too, since both the reality of infectious disease and attempts at preventing it cause economic slowing. Remember SARS? That’s a much less scary virus than H5N1, but the responsible actions to contain its outbreak still had a significant economic cost.

Now, in investing, a good defense is also good opportunistic positioning. If you’re concerned about a slowing economy or a sharp economic shock, bonds are a smart investment choice. In the first place, bonds will make you money while you hold them. In the second place, the inflation and interest rate hikes that bonds hate aren’t much of a risk when growth slows. In the third place, money in bonds is liquid and fully deployable in the event that a fire sale shows up in other markets like stocks. And in the fourth place, if your paranoia about slow grow or shocks is misplaced, your bonds will make you money while you hold them in the first place.

Bonds aren’t for sissies. They’re a smart investment that can play a role in both the defense and offence strategies in your portfolio.


© 2006 John Caspar