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October 26, 2006
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Fixed Income Assets – Part II
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Questions from readers...
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In my column last week I talked about the role bonds play in a portfolio. The article spurred a number of questions from readers. One from Mr. G, asked me to explain the formula used to price a bond in the market place.
Mr. G’s question goes to the heart of why bond prices change when interest rates change. Simply stated, it reflects the fact that the bond’s coupon (the coupon on last week’s example was 9% for a Government of Canada bond maturing March 1st, 201) and term to maturity (2011 in our example) are both fixed. Because these elements are fixed, and since bond returns must maintain some kind of relationship to what current interest rates are, something has to give, and that something is the bond’s price.
In the current market, investors are willing to pay $100 for a 4.25% coupon bond, maturing in 4.5 years (that’s the same term to maturity as our 9% bond). Based on current interest rates, someone holding a $100 bond would receive $4.25 in interest for the next 4.5 years for a total return of $19.125 ($4.25 interest income x 4.5 years).
Since current rates are less than half the coupon of our 9% bond, no one would sell that 9% bond for $100. As an incentive to sell, the investor holding the 9% bond would demand a premium, something in the order of $120 per $100 face value.
The premium effectively puts the 9% bond on par with current market rates. Think about it this way. The investor buying the 9% bond receives $9.00 per year per $100 face value in interest for the next 4.5 years. The total return then is $40.50 in interest income ($9 per year x 4.5 years).
The bond matures at $100 in 4.5 years, which means the investor paying a premium would lose $20 in principal (the total value of the premium). The total return for the investor would be $20.50 ($40.50 interest less $20 principal), which closely equates to the $19.125 total return in the current market. The difference in the two numbers reflects the fact that the premium is paid on day one and erodes over the next 4.5 years.
If you want a more complete explanation with a example of the formula at work, go to my website (www.croftgroup.com). At the home page click the pull down menu “Planning” and then click “Portfolio Tools” and then “Bond Valuation.”
Mr. A also had a couple of questions; His first asked how the premium or discount is taxed if the bond is held outside an RRSP? An interesting question, because if Mr. A is taxed purely on the interest payment, a 9% bond will result in a harsh after-tax yield given the premium paid.
To address the question, and for the record, I am not a tax expert, if a bond is sold prior to maturity, any gain or loss on the bond’s price is taxed as a capital gain or capital loss.
Mr. A’s second question asks whether it makes more sense to buy an index bond fund like iShares (symbol XBB, listed TSX) which has a much lower fee than actively managed bond funds, with management fees often in excess of 1% per annum.
When dealing with fixed income assets, indexing tends to be a good strategy. However, indexing versus active management really comes down to whether you believe active managers can add value. All I can say is that with bond yields so low, it is difficult to for active managers to add much value in the current environment.
Finally, Mr. L writes, “As a consumer, I have run into difficulties attempting to set up a laddered bond portfolio, although I have dealt with a large discount brokerage house for over 20 years. My concern is that the discount brokerages have a very limited selection of bonds.” The latter point is probably correct, because discount brokerage firms tend to offer a selection of bonds that are liquid but that proves only the basic elements of a laddered bond portfolio.
Mr. L raises another point about transparency; specifically the lack of transparency when it comes to fees, makes it difficult to understand what the true cost of a bond is. Mr. L’s point reflects the fact that bonds are not typically traded on an exchange where, for example, stock prices are transparent. Instead bonds are generally bought and sold from dealer inventory, which means you are buying from and selling to the broker. Not always the best situation for average investors.
Having said that, I look forward to hearing from dealers as to their views about transparency. As well, if you have any questions about your portfolio feel free to send me an e-mail at
rcroft@croftgroup.com.
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