Thursday, February 5, 2009

Bonds and Strip Bonds

A good use of bonds for your portfolio is after you start to take money out after retirement. If you are dependent on your investments to live, you need to have enough cash, with income from investments etc., to last 3 to 5 years into the future. You never want to be in a position where you must cash in an investment. What you want to do with bonds is have what is called a ladder portfolio. That is having bonds due in increments of 1 year, 2 years, 3 years and 4 years. You do not need to have a bond, say issued for 4 years, but a bond with only 4 years to run. For example, it could be a 30 year bond, but it matures in 4 years time.

First, the rate of return on bonds can vary and they vary because of perceived risk. For a bond, the higher the interest rate given, the higher the bond’s perceived risk. You can buy bonds of countries, municipalities, cities and companies. If you are buying corporate bonds, your risk depends on what company’s bonds you buy. This is really no different from stocks. Secondly, if a company goes bankrupt, bonds holders are ahead of preferred share holders and common share holders in getting their money back.

To buy bonds you really must speak to the Bond Desk with the bank you where you have your trading account. You do not want to speak to the people who sell shares, what you want is the bond desk. You do not pay a commission when buying or selling bonds. There is a buying price and a selling price for a particular bond. It is on the spread between these two prices where the bank makes the equivalent of a commission. You can see in the newspapers what bonds are for sale and at what price.

You will find a bond primer at I cannot find a Canadian bond primer site. Please note that in Canada, we have different tax laws and there are no tax free bonds available.

You buy bonds in denominations of $1,000, but they are sold per $100. If you pay $97 per $100 for a bond and you keep it until maturity, you will get back $100 for each $97 you pay. You will have a capital gain. If you pay $103 per $100 for a bond and you keep it until maturity, you will get back $100 for each $103 you pay. You will have a capital loss. The bond market is generally more volatile than the stock market. It can be made safer if you hold a bond to maturity. Say you want to hold a bond for 5 years; you should buy a bond due in 5 years time. That is, you do not need to buy a 5 year bond, just a bond that matures in 5 years.

When you buy a bond, you will be quoted an interest to maturity. That is the rate you will earn on the bond, and this rate to maturity includes the capital gain or loss. If the interest rate quoted is 7%, this means that the interest to maturity is 7% or that you will earn 7% annually on your bond.

A strip bond is bond where both the principal and regular coupon payments (which have been removed) are sold separately. A strip bond is also known as a "zero-coupon bond." An investment firm will usually buy a debt instrument and "strip" it into its separate parts. That is someone buys a stream of income (interest payments), and someone buys the maturity value of the bond. When you buy a strip bond, you are buying the principal payment due at the end of the bond’s term. That is if a bond is a 10 year bond, you are buying the principal that is due in 10 year’s time. Strip bonds usually trade at a discount and mature to par value. (When they say trade at a discount, it is the example above where you pay $97 per $100 of bond value. When a bond is trading at a premium, it is the example above where you pay $103 per $100 of bond value.)

The implications of taxation in Canada on a strip bond is that even though you do not receive any interest on these bonds, Revenue Canada requires that you pay tax on the interest you would have received, had it been a regular bond. See a discussion on this.

Another thing you should realize in buying bonds is the bond’s capital and interest rates go in opposite directions. That is if the interest rates go up, the amount the bond is worth goes down and vice versa. Currently bonds have very low interest rates and some government bonds have almost 0% interest. They really cannot go lower. However, there is also a wide variance between some corporate bonds and government bonds. The variance is much wider than normal. It is difficult to anticipate how this will play out. Certain, government bonds will have an increase in interest rates in the future, as they cannot go down.

This blog is meant for educational purposes only, and is not to provide investment advice. Before making any investment decision, you should always do your own research or consult an investment professional. See my website at for a list of the stocks for which I have put up spreadsheets on my web site.

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