Archive for August, 2010

h1

Bonds

August 30, 2010

If you are considering bonds, which I would do only sparingly at present, and for the purpose of rounding-out your risk/reward allocation, choose corporate bonds. Corporate Bonds have a return yield higher than government bonds and T-Bills, which right now are very uninteresting, unless you are strictly looking for negligible return sources to keep your portfolio volatility low.  But beware, this line of thinking has created a  heavy flow of money into corporate bonds making them very popular.  As the basic law of bonds assumes, this only drives the yields down further making them less ‘return attractive’ (i.e. as demand and price increases, the  ‘interest’ paid to the bond holder becomes lower and lower as the product become less exclusive in the market).  Even from the standpoint of safety, they, in time, become only marginally more interesting than money market instruments and with a great deal more complexity.  Investors demand higher yields from corporate bonds as compensation for higher risk (hence a return spread between the two is created). The logic here is based on the assumption that the Bank of Canada will not immediately increase interest rates, which, simply speaking, would kill corporate bond yields as regular interest bearing accounts would now pay better ‘interest.’  In the mean time, and as we have a very fussy market, the flight to safety has investors willing to take advantage of this return spread (between corporate bonds and government instruments) for the purpose of receiving the best, and safest, return irrellevant of the equity market.

However, as I pointed out in my facebook status (http://www.facebook.com/pages/Halifax-NS/Jeff-H-Barrett-CIM-Investment-Planning/110920738955909?v=wall) there are more advantageous choices at present amongst equity groups who have maintained or grown their dividend in the past 2 years. The dividend yields alone can outperform the bond market even if the stock/fund price moves insignificantly. There will be a time for bonds, I can assure you, but its at the other side of the market. Until then it appears as if the spread is not worth the extra anxiety.

If you’re still convinced and want to take more risk in exchange for even greater yield potential, you can look at companies with lower credit ratings (but probably only as far as BBB ratings unless you are savvy, knowledgable, and aware of the risks below that credit rating). Conversely, you can hoard money market instruments and money itself as companies are doing. For another discussion I will discuss that I believe it is important for families to look at themselves as a business (cash flow, retained earnings, debt, etc) and to look at what companies are doing in different financial scenarios as a bit of a role model on how to be profitable as an entity. We, as a society in North America, are terrible at understanding cash flow vs. debt. We spend 130 dollars for every 100…businesses fail of far less. But I digress…

At present, the very low-interest rates and the increasing insecurity over the matter of recovery create an incentive for companies to release debt because it keeps their interest payments to lenders very low but at the cost of cash flow. We all know that I am a fan of consistent cash flow as it presupposes future dividend (if paying), and company growth without the need to resort to lenders. This debt is released to a market primed for principles of safe and secure returns and marketed to investors as a spread opportunity over money market instruments. This desperate need to earn back returns after the recent (and ongoing?) crisis has made high credit rating corporate debt very popular, especially when paired with equity from the same company.  As the market begins to recover, money will begin to flow into corporate debt of companies with a lower credit rating (who are forced to pay higher ‘interest’ to you to compensate you for taking on proportionatly higher risk) on the assumption that the improving market will protect that higher risk. Since this spread is even bigger than the one between high credit rating companies and government debt, they hope to earn higher returns.

All of this shows you, however confusingly, that there are opportunities in every market condition. And if you are more familiar with stocks than bonds, you can achieve the same results by simplifying your investment strategy. How much can 5000 dollars buy you when the price is half of what it will be? Twice as much right? Bonds are excellent for taking some risk out of your portfolio and providing an income stream (‘interest,’ which is actually called a coupon payment), and are excellent when the coupon and yield you are receiving is higher than government interest rates because then your bond pays better than the government and becomes very much in demand. There are spread opportunities to gain a few extra percentage points (at best) depending on market conditions. Perhaps, though you should leave that to the savvy and professionals.

Advertisements