Fixed Income 101; The Good, The Bad, And The Ugly
For 35 years (until about 18 months ago) we have been in a declining interest rate environment. If you bought a 30 year bond at that time you would have earned about 13.85% a year for the next 30 years and then received your money back (you also could have sold the bond during that time). I can remember working with London Life just over 20 years ago and suggesting to people to lock in their money till age 90 at the rate of 11 ¾ percent (you could do that then) and I met stiff resistance. Why? Because only a short time before that you could get 12-13 percent and people were afraid of locking in and missing out if rates went back to 13%.
One of the quirks of human nature is that we base most of our decisions on short term quirks rather than the long term norm. This is a trait that we have to ‘fight’ against every day.
FACT: when you buy a 5 year bond or preferred share you are buying an income stream that is FIXED (hence the term fixed income). NOTHING ELSE IS FIXED! (I mean the price of the security)
During the 5 years before maturity or price reset the price of the bond/preferred share will fluctuate BECAUSE it has liquidity (you could sell it if you had to). GIC’s do not have any price change which may seem ideal BUT you are locked in for the term and have ZERO LIQUIDITY. GIC’s also will have less return than a preferred share and you will pay more tax on the interest from a GIC.
REMEMBER-URGENT: Volatility is not a loss!!! BONDS PAY OUT THE FACE VALUE AT MATURITY and PREFERRED SHARES RESET THEIR INCOME STREAM AFTER FIVE YEARS (this is your protection)
Your statements show the current selling price of bonds…not the maturity value. Focus on the income generated by the bond and the return of capital at maturity.
The chart below show an example of how the price of a bond might change in a rising interest rate environment (please remember rising rates are BAD for the bonds you already own). In the short term the POTENTIAL selling price of your bond may be less BUT the maturity value is constant. The positive is that you have liquidity BUT the selling price of the bond will be adjusted for current interest rates. As you can see the riskiest time is early on in the term of the bond.
There are other reasons that the price of a bond may fall and one of those is liquidity and lack of familiarity with the business.
An example of that is the bonds for INVESQUE. A company that invest in global health care real estate. I find it hard to think of a better business with current demographics.
Their 4 year bond paying 5% is selling for $80 and the 6% 5 year bond is selling for $75.
THESE BONDS ARE PAYING AN ATTRACTIVE INTEREST RATE (DOUBLE A 5 YEAR GIC) AND AT MATURITY WILL CREATE A 25%+ CAPITAL GAIN BECAUSE THE BOND WILL MATURE AT PAR ($100)
SUGGESTION: BUY THESE BONDS (IDEAL FOR RRSP/RRIF AND TFSA)
(I also like the equity of this firm which also trades at a SUBSTANTIAL discount and has a 9% distribution yield at current prices)
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‘historical analysis does not reflect future returns’