Building a base with fixed income

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Gail Bebee is the author of No Hype - The Straight Goods on Investing Your Money. She can be reached at gbebee@gailbebee.com; her website is www.gailbebee.com. This is part six of a 12-part series for people that are new to investing on their own.

Fixed income: A type of investing or budgeting style for which real return rates or periodic income is received at regular intervals at reasonably predictable levels. Investopedia

I must confess that I left the topic of fixed income until now because I find the subject boring. However, that is as it should be. Fixed income is the financial Rock of Gibraltar of investment portfolios - an unadorned, indestructible mass that provides stability through the good times and the bad times, like 2008.

While fixed income choices abound in today's world of financial engineering, I think direct investors should stick to fixed income investments that deliver low risk, predictable returns. That means investment quality government and corporate bonds, guaranteed investment certificates, T-bills, high-interest savings accounts, government savings bonds, mortgages and mutual funds and exchange-traded funds which invest in such assets. Forget the complex fixed income products you don't understand. I'm sure the folks who bought "safe" fixed income asset-backed commercial paper would agree. It really wasn't safe and there was no income!

In this article I'll focus on bonds since new direct investors will be less familiar with this area of fixed income.

A bond is a debt instrument that is issued by an institution, such as a government, utility or corporation. It's a way for these organizations to borrow money for operational purposes such as buying new equipment, paying off existing higher interest debt etc. The bond issuer agrees to pay fixed amounts of interest, called coupons, periodically (usually semi-annually) to the bond buyer and repay the amount borrowed on a specific future date. The face value of a bond is called "par value," usually $100 when the bond is issued. The term of a bond can be from 1 to 30 years or longer. Canadian and U.S. bonds should be readily available from Canadian discount brokers.

Investors make money on bonds from the interest paid. They might also make a capital gain because bond prices fluctuate above and below par value, depending on current interest rates. Bond prices rise when interest rates go down because the marketplace prices existing bonds such that their total return is equivalent to the interest rate of new bonds. The converse also occurs: if interest rates go up, bond prices fall.

Bonds are considered safer than stocks because bondholders have a greater claim than stockholders on the bond issuer's assets if the issuer goes bankrupt. However, this doesn't mean you get your money back if the issuer goes into bankruptcy. Consequently, you need to pay particular attention to the quality of the bond, known as its credit rating.

Moody's Investors Service, Standard & Poor's (S&P) and Dominion Bond Rating Service (DBRS) are the main bond credit rating agencies. Look for bonds that are rated investment quality by at least two agencies: at least BBB- (S&P), Baa3 (Moody's), BBB (low) (DBRS). Government of Canada bonds attract the top rating, AAA, and offer the lowest return rates. Provincial bonds and the bonds of Crown corporations are also highly rated and have slightly better interest rates. Corporate bonds are the riskiest. They may be investment grade when you buy, but circumstances change. Bonds of the big three American auto makers were once investment quality!

Here is a typical discount broker bond quote decoded:

Unlike stocks, bonds do not trade on an exchange and the sales commission is hidden inside the bond's price. So, it's difficult for the retail investor to know if the commission is reasonable. Your discount broker might tell you the commission if you ask. To get an idea of current bond prices in the marketplace, visit www.CanadianFixedIncome.ca . I think it makes sense to hold bonds to maturity to keep these unknown transaction costs low.

When you invest in bonds directly, diversify. Own a mix of bonds from different organizations and stagger the maturity dates to create a bond ladder. With a ladder, when a bond comes due you are only reinvesting part of your bond allocation, reducing the risk of reinvesting at a low interest rate. For longer investing time horizons, include some real return bonds to provide a Consumer Price Index-adjusted investment return and help protect against inflation.

Retail investors may never get their hands on the best bonds - institutional investors scoop them up quickly. Couple this with commissions that are unknown and it's not difficult to conclude that the bond investing decks are stacked against the small guy. Maybe it's just easier to let an exchange-traded fund manager do the job. iShares CDN Bond Index Fund , with a management expense ratio (MER) of 0.30 per cent, or a combination of the Claymore 1-5 Yr Laddered Government Bond ETF , MER 0.15, and the Claymore 1-5 Yr Laddered Corporate Bond ETF , MER 0.25, would work. Add some iShares Cdn RealRt Bond ETF , MER 0.35, for protection against inflation and perhaps a small holding of a global bond fund and you've got a respectable, low management fee bond portfolio which requires minimal ongoing effort.

Last year's stock market crash reacquainted us with the concept of investing risk. It served as a reminder that low risk fixed income deserves a permanent place in the portfolio of virtually all investors.