Our Recommended Broker

Get $50 in free trades.
Questrade Democratic Pricing - 1 cent per share, $4.95 min / $9.95 max FAQs
Home
Disclaimer
Learning Topics
Contact Us
FAQ Archive

Why should most investors own fixed-income assets such as bonds?

Fixed-income investments can add stability to your portfolio and over the long-term will generally move in opposite directions to stocks. When stocks are doing badly, their poor performance can be offset by the stability of fixed-income assets such as bonds. Of course, there's no guarantee that you will not lose money investing in fixed-income investments.

The performance of fixed-income investments is directly tied to the trend in interest rates.

As interest rates rise, the value of your bonds will fall. This is because the interest or coupon paid on your bonds would then be less than the new interest rates. Investors would put a lower value on your bonds because they pay less interest than the new going rate. The opposite happens when rates fall. The value of your bonds will rise because they will then be paying a higher coupon than the new going rate.

A key factor affecting the value of your bonds is their average term-to-maturity. This is the number of years before the bonds you hold can be cashed in for their face value. Long term bonds, those that mature in 10 in more years, are more volatile than short-term bonds when interest rates change. This is because they are more subject to uncertainties such as inflation eroding their value.

Other factors affecting the magnitude of your bonds' reaction to rate changes are the coupon size and credit quality of your bonds.

Credit quality refers to the financial strength of the government or corporation issuing the bond, and the likelihood that the issuer will pay interest on time and repay the principal amount on the bond's maturity date.

Lower average coupons and lower average quality will make your bond portfolio more volatile. Bonds with higher coupons are less sensitive to interest rate changes. This is because the higher coupon reduces your risk by giving you more of your return earlier in the bond's life than a bond with a lower coupon. If interest rates rise, you will have receive a greater return on your initial investment than someone who bought a lower coupon bond.

Bonds are used by investors who want a steady income, in the form of interest payments. You should keep in mind that the interest income is taxed at your full tax rate. This makes bonds an attractive holding inside a tax shelter - such as your RRSP.

By building yourself a bond ladder, you have a simple way to invest in bonds without having to worry about the direction of interest rates.

Instead of having all your bonds come due at the same time, you use the ladder to spread out the maturity dates. This avoids the risk of having all your bonds up for renewal at the same time when rates might be low. If rates had gone up when you renew, some of your bonds would catch the higher rate.

With your maturity dates staggered, you enjoy income stability. You have an easy way to manage your bond portfolio yourself. As each bond comes due, it's renewed at whatever the longest term bonds in your ladder are. Under passive approach, you do not attempt to guess where interest rates are headed.

Example

Imagine that you want to create a 10-year bond ladder. You could buy a Government of Canada four-year bond, a six-year bond, an eight-year and a 10-year. As each bond comes due, just remember to renew it for 10 years. Four years from now, your four-year bond would come due. You would renew it for 10 years. When the six-year bond comes due in six years, it would be renewed for 10 years, and so on.

Interest income isn't the only type of return you can get from bonds. They also have potential to earn a capital gain.