We’re getting a very much unwanted lesson in how bonds work in a financial crisis.
Government bonds hold their ground reasonably well, but investment-grade corporate bonds have fallen in price. A reader has noticed this trend in his own portfolio – a bond issued by a real estate investment trust has experienced a “large drop” in value. This reader asks: “Am I guaranteed my annual return if I held to maturity?”
Bond interest is not guaranteed like, say, a guaranteed investment certificate. In the corporate world, bonds are considered comparatively safe because bondholders rank ahead of both common and preferred shareholders if the company is having financial trouble. In other words, interest on bonds is top priority, followed by preferred-share dividends and then common-share dividends. But a default on payment of interest or even redemption at maturity is possible.
Look to a bond’s rating from a firm like DBRS for an indication of default risk. Ratings of A, AA or AAA offer a high level of assurance that the risk of default is minimal. A BBB rating is the minimum for a bond to be considered investment-grade, which indicates a certain level of financial stability. BBB-minus or lower puts a bond in the high yield, or speculative, category, which indicates a higher level of risk. High-yield bonds are considered to have a risk profile closer to stocks than bonds.
A price drop on a corporate bond in today’s market may reflect generalized concern about the economy and rising default risk. Arguably, there’s a buying opportunity right now for the bonds of financially resilient companies that have been caught in the negative sentiment toward corporate bonds in general. Remember, falling bond prices push up yields. Five-year Government of Canada bonds were yielding about 0.6 per cent at the end of March, while exchange-traded funds holding corporate bonds were yielding about 3 per cent. By the way, corporate bond ETFs are worth considering if you’re looking to buy low in the corporate-bond sector – they reduce default risk by holding a diversified portfolio of bonds.
Corporate bonds are not guaranteed, though. For that, consider the GIC alternative. In fact, don’t buy an investment-grade corporate bond today without checking yields on GICs issued by online banks and credit unions.