Fixed Income 101: Carefully plan debt investments

Fixed income is an asset class that includes short term money market instruments, term deposits, GICs, government bonds, corporate bonds, debentures, and bond funds.  All of these investments are considered “debt” investments rather than “equity” investments.

When buying debt investments an investor is essentially lending money to the issuer of the bond.  For example, a company that needs to raise money generally has two ways to do so – issue stock in the open market or borrow.  By issuing a bond, the company is promising to repay money at maturity, along with, interest.

When purchasing fixed-income investments there are several things you should consider:  credit quality, liquidity, yield-to-maturity, term-to-maturity, and expected income stream of the investments.  The following five questions provide a framework to assist you in evaluating the relative merits of a particular investment.

1. What will my return be?

In order to determine how much you will earn on your fixed income investment, you generally need to consider two things: the coupon of the bond, and the overall yield.     The coupon is the percentage of the bond’s face value that you will receive as income on a periodic basis.  Most bonds pay coupons twice a year.  Yield (called yield to maturity for bonds) is often the more important number to review as it allows bonds of different coupons and maturities to be compared to each other.  Yield to maturity is the total return, made up of interest and repayment of principal that you will receive if you hold the bond to maturity.

2. When will I get my money back?

Most fixed-income investments are issued for a specific period, such as five years, and have a set maturity date.  This is the date on which the face value or principal amount of your investment will be repaid by the issuer, or borrower.

3. How safe is my investment?

You should always check what type of security or guarantee is behind your investment.  Most bonds are not backed by specific assets, but are backed by the full faith of the issuing company.  An investment is considered to be extremely safe and have high credit quality when there is little likelihood that the issuing government or corporation will default on interest payments or not repay your principal.  Bond rating agencies provide investors with information to assist them in gauging the credit quality of their investments.  Lower quality companies will have a higher likelihood of not paying out and therefore be rated lower.  Lower quality bonds will offer a higher yield to attract investors.  Remember higher risk, usually means higher return.  Higher quality bonds, with little chance of default such as Government of Canada, have a lower yield.  You should choose a balance of risk and return that meets your tolerance level.

4. Why is the price changing on my bonds?

Before investing in bonds, you should be aware of any potential volatility that could affect the value.  GICs are an example of a type of fixed income investment that do not fluctuate in value.  However, regular bond prices are affected by moves in interest rates, and therefore prevailing yield in the marketplace.  Bonds prices move inversely to the prevailing interest rates.  As rates go up, bond prices come down and vice versa.  Generally, if a bond has a coupon that is larger than the prevailing yield in the market, the bond will trade above 100.00, considered a premium.  Conversely if the coupon the bond is lower than the prevailing yield in the market, the bond will trade below 100.00, considered a discount.

Bond prices are more likely to remain stable when they are high quality, more liquid and have a shorter term-to-maturity.  Changes in the price of bonds can present different opportunities for active investors.  However, if you plan to hold a bond investment until its maturity, you will receive its face value, therefore, market volatility will not be a factor (provided no default).

5. Can I sell my fixed income easily?

Although you may intend to hold a fixed income investment until maturity, you should still obtain an understanding of its liquidity.  Circumstances may change and you may require cash.  Some fixed income investments are extremely liquid which means that you can sell them easily before they mature.

If you sell a bond between periods of receiving coupon interest you will receive from the purchaser the accrued interest you have earned up to that date.  Less liquid bonds may be harder to sell in the secondary market.  GICs are different than bonds when it comes to selling.  Cashable GICs should not be redeemed within 30 days.

Early redemptions generally result in a loss of interest.   Cashable GICs are usually classified as cash equivalents rather than “fixed income” because of their liquidity and short duration (one year or less).  As for non cashable GICs, investors may be able to find a market to sell.  It is not advisable to buy GICs if you know you may need the money