The big idea behind owning bonds is unravelling in 2021.
Bonds are supposed to provide stability, with minimal drama. What we have now in the bond market are sizable year-to-date price declines and a one- to two-year outlook for more of the same. Although bonds rallied Friday amid weak jobs reports, the economic rebound is expected to gather steam in the months ahead and may add upward pressure to bond yields, weighing on prices.
Most investors need some degree of fixed income exposure for protection against a serious stock market decline. The challenge right now is to pick the right type of bond exposure to provide this portfolio insurance while offering some degree of predictability as rates rise.
For help on this, we’ve put together a chart to help investors find the most comfortable fixed income fit for their portfolios. Five bond options are evaluated in the following areas:
- Generating yield: Even in today’s low rate world, bonds still generate a flow of income.
- Managing sensitivity to rates: Some fixed income options are less sensitive to rate changes than others.
- Fees: Bond funds have fees that reduce returns.
- Predictability: Some fixed income investments mature and return your capital to you, while others do not.
- Liquidity: Some fixed income options can be sold during bond and stock market trading hours, others must be held to maturity to avoid a redemption penalty.
The bond options under consideration here are actual government and corporate bonds, exchange-traded funds that hold bonds, bond mutual funds, guaranteed investment certificates available through online brokers and GICs available in the wider market (they may offer higher rates). The bond and bond ETF examples used here include government and investment-grade corporate debt, which means companies that have strong to stable financials.
We’ll assume you’re a DIY investor with $10,000 to invest in fixed income, a term that includes bonds, GICs and, to some investing industry people, preferred shares as well. I think preferreds are equity – stocks, in other words. They do pay reliable income, but the price is too volatile to compare with bonds and GICs.
Here’s a definition of the terms you’ll find in the chart that follows:
Market price: Bond prices are quoted per $100 of par value, which is the amount you get at maturity. Many bonds these days trade at prices above their par value. Bond ETFs trade like a stock, which means current pricing is available on any stock quote website; with GICs, you simply pick how much principal you want to invest – some issuers may have minimums of $3,500 to $5,000 and up.
Cost of buying: The full cost of buying bonds includes a commission and accrued interest, which is interest owed by the buyer of a bond to the person selling.
Maturity: Bonds and GICs mature on a specified date, while bond ETFs and mutual funds fluctuate in price over time according to interest rate cycles and never mature.
Yield: For bonds, yield is a calculation based on the coupon (the interest rate on a bond when issued) and the market price; for bond funds, overall yield is based on the holdings in the portfolio and the fee (fees reduce yield).
Duration: Expressed in years, duration shows you the percentage decrease/increase in price that a bond or bond fund would experience if interest rates rose/fell one percentage point. If interest rates rise by one percentage point, the price of an ETF with a duration of five years would fall 5 per cent; a lower duration means less sensitivity to rate changes.
Liquidity: How easy is it to sell a fixed income investment if it no longer suits your needs or you want to rebalance your portfolio? Bonds and bond funds are easily sold and thus offer full liquidity. GICs allow redemptions only with severe penalties. Cashable GICs are available, but with lower yields.
Fees: Bonds cost nothing to own on a continuing basis, and neither do GICs. Bond ETFs have fairly small management expense ratios, while bond mutual funds have much larger MERs. The MER is taken off the top of fund returns, which are reported on a net basis to investors.
Commissions: Included in the price a broker quotes for a bond and generally much larger than commissions for buying stocks; with bond ETFs, you pay a brokerage commission of up to $9.99 to buy; bond mutual funds and GICs are widely available with no commissions to buy or sell.
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