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The Companion Advisor: Fixed Income
Bonds Part 2: Harnessing the factors

A Companion Advisor Article

Depending on your investment objectives and the general economic climate, you may decide to invest in a bond mutual fund. When assessing funds and reading fund reports, there are several terms that will help you appreciate the factors a bond fund manager must consider.

Maturity is the life-span of a bond, after which interest payments cease and the original debt to you is repaid in full. Bonds are usually issued for maturities ranging from one to 30 years. Bonds which mature within three years are called "short term", from three to 10 years are "medium term", and more than 10 years are "long term".

The stated amount of interest on the bond, called the coupon rate, is paid throughout the term. However, changes in the direction of interest rates in the economy can have a significant effect on the value of the bond if it is sold.

When interest rates are declining, bonds usually increase in value. If bank deposits and T-bills are paying 5% interest, a bond paying 10% interest is very attractive, and people are willing to pay more for it.

Selling a bond for more than the purchase price will result in a capital gain, and total bond returns include capital gains and interest. In times of declining interest rates, bonds thus become excellent investments.

For example, for the ten years ending December 31, 1995, The TSE 300 Index returned 8.3% while Canadian Bonds, as measured by the ScotiaMcLeod Universe Bond Index, returned 11.3%. Canada led the 11 most-industrialized nations in bond returns for 1995 at 20.4%.

Interest rate changes have a stronger effect on the price of longer-term bonds. If prevailing interest rates are at 5%, a 10% coupon rate for a 10-year bond is worth more than a 10% coupon rate for a one-year bond. Therefore, when interest rates are expected to continue to go down for some time, fund managers will usually try to lengthen the term of the bonds in their portfolio to achieve maximum benefit. When interest rates are at their lowest, or expected to rise, fund managers will usually try to decrease the average maturity of their fund in order to cushion the negative effects.

Also, longer-term bonds usually pay higher coupon rates. Money borrowed for a longer time is more expensive than money borrowed for a shorter time because more things can happen over a 20-year period to endanger the repayment of the debt than over a one-year period.

This relationship of maturity length to coupon rate is called the yield curve, and can be plotted on a graph. A steep yield curve means that longer term bonds pay a lot more than shorter term bonds. A flat yield curve means that all maturities pay about the same. Occasionally, a yield curve becomes inverted with shorter maturities paying more than longer maturities. This happens in times of great demand for short-term money. (see coupon vs. yield)

Maturities, coupon rates, and yield curves are all factors that bond fund managers watch daily. As a bond fund investor, you trust your manager to be making good investment decisions, and a basic understanding of these terms helps you to understand trades and purchases your fund manager might make. The advantages of investing in a bond fund rather than bonds directly are professional money management, diversification among maturities, a variety of purchase plans, and liquidity.

In times of declining interest rates, bonds offer the best of both worlds: interest income and capital gains. In times of rising interest rates, bonds offer a steady source of income even though the underlying value of the bonds themselves declines.

Over long time frames, stocks tend to outperform bonds. "Canadian Stocks, Bonds, Bills and Inflation: 1950-1987", a study written by Dr. James Hatch and Dr. Robert White, compared various investments over time. For one-year periods within their time frame, stocks did not provide significantly greater returns than bonds or T-bills. However, for ten-year periods, which included the 1987 tumble, stocks outperformed bonds and T-Bills in 29 of the 32 periods from 1950 to 1991.

As well, the compound annual return on stocks from 1950 to 1991 was 10.8 per cent, well ahead of the 6.6 per cent for bonds and the 6.4 per cent for T-Bills. The study suggested that an investor's potential returns on stocks will exceed the potential returns on bonds and T-Bills as long as the investor holds the stocks for at least five years.

Nevertheless, bonds often deserve a place in a well-diversified portfolio. The size of that place depends on your investment objectives. Fiscal Agents offers many different types of bond funds from Canada leading Fund Managers.

Typical Bond Fund Groups

Canadian Bond Fund - Government of Canada Bonds

Global Bond RSP Fund - Bond Futures and Government Bonds Worldwide

Global High Yield - Emerging Market Bonds

World Bond Fund - Government Bonds Worldwide

As well as Balanced Funds which combine bonds and equities:

Canadian Balanced Fund - Common Shares, Government Bonds & Treasury Bills Canada

Canadian Income Fund - Common Shares, Government & Corporate Bonds Canada

International Balanced Fund - Common Shares, Government and Corporate Bonds Worldwide

International Balanced RSP Fund - Common Shares, Bonds, Future & Forward Contracts Worldwide

Ask your Fiscal Agents - investment advisor about bonds, they may be just right for you.