The two-year total returns exceed the one-year returns for the same yield movement because there is one more year of compounding and because the bonds are now shorter in maturity by two years and thus less volatile.
Maturity Selection. Bonds come in a wide range of maturities, from thirty days to more than thirty years, allowing for appropriate retirement planning and ladder building (more on this in Chapter 8). Bond funds and ETFs do not have maturity dates so investors do not know how much money they will have when they need to redeem their units.
Liquidity. Bonds can be sold at any time, should raising money become important or should other opportunities present themselves. Daily trading volume averages over $38 billion, with the major investment dealers maintaining bids and asks on the complete array of fixed-income products that have been issued. Mutual funds can only be redeemed daily.
Bond Indices
There are several bond indices in the Canadian bond market. One of the most widely used for bonds in Canada is the DEX Universe Bond Index™ produced by PC Bond (www.canadianbondindices.com). This index encompasses some 1,103 different bond issues totalling some one trillion dollars and is constantly being rebalanced so that it fairly represents the overall bond market. As of December 31, 2010, it consisted of 46 percent in federal bonds and federal guaranteed bonds, 27 percent in provincials and municipals; and 27 percent in corporates. The corporates are further weighted by credit rating. The average duration was 6.27 years. Duration is a term that refers to the average term of the bond, taking into account the weight of the interest payments. Thus, duration is shorter than the term to maturity and is a measurement of the volatility of a bond. (More on this later.) This index is further divided into maturities with 45 percent being one to five years, 24.2 percent from five to ten years, and the balance of ten years and longer at 30.8 percent. There are many other sub-indices as well.
For the twelve months ending August 31, 2011, this index returned 5.35 percent while Canadian-managed bond funds returned a median of 3.50 percent. This gap is partly explained by the fees charged to the fund by the manager. This is called the management expense ratio (MER), which averaged approximately 1.7 percent in this period (source: globefund.com).
What to do then? I referred in the introduction to a strategy called laddering, which is fully explained later. Suffice it to say here that laddering takes the guesswork out of interest rates, reduces fees, and, over time, outperforms the majority of bond fund managers. This is done with individual fixed-income securities of staggered maturities. Basically, it is the most effective way of dealing with reinvestment risk, as your investments are spread out over regular intervals. This approach eliminates the need to guess which way interest rates are going, as investing in bonds of different maturities avoids the risk incurred if all your funds were invested in one maturity and interest rates were very low when that investment matured. There will be more on this important method in Chapter 8.
It is in your best interest to take control of your financial future by arming yourself with the knowledge of how to invest in individual fixed-income products. Doing this will offer you greater certainty as to the future value of your money and cost you less in fees.
Chapter 2
How Do I Get Started?
It is likely that you already have a relationship with an FI and/or an IA. It may be a bank, a bank-owned investment dealer, an independent brokerage firm, a mutual fund company, a financial planning company, a life insurance company, or a trust company. All of these entities, through their IAs or agents, first attempt to sell you their products, even if they are not suitable for you. Very few IAs (my guess is 10 percent) actually have your best interests in mind. Therefore, you will have to arm yourself with all the knowledge you can and find an experienced IA to act for you.
Your IA’s firm will have lots of educational material available and there are a plethora of websites to help you along. I have included this list in Appendix A. These websites offer all kinds of analytical tools. The daily newspapers offer some commentary, and television shows such as CNBC and the Business News Network (BNN) have expert commentators on a regular basis, including me. There are books available, and your IA’s firm will likely offer daily, weekly, and monthly bond market commentary. Over time, all of this information will stand you in good stead as you will have a good knowledge base.
So, armed with all this knowledge, you should be able to get your broker/advisor to do what you want, shouldn’t you? Not necessarily! Each pillar of the financial services industry (banks, trust companies, mutual fund companies, life insurers, investment dealers, and advisors/planners) has a vested interest in selling you what is in its best interest, not yours. Rare is the organization (or individual) that actually listens well enough to ascertain the needs of the client and takes care to make sure those needs are met, even at the expense of a sale that might produce greater near-term reward.
How and where do you find such people? The number one method is referral, from an IA’s satisfied clients or from lawyers, accountants, and friends. Ask, ask, ask, and eventually you will find someone who will help you. At some point, you will likely receive what are called cold calls. These come from IAs just starting out who are trying to build their books. It is in your best interest to find IAs with experience and well-established books of business so that you are well served. It is a further bonus if they offer fee-based services and thus are not driven by the need to generate commissions on every trade. It is possible that you may not find such IAs or your account may not be large enough for them. The major investment dealers offer superb training for new IAs, which includes the fixed-income markets. Therefore, you may find a newer IA who might be suitable for you, but remember to ask, ask, ask.
IAs’ books of business refer to how many clients they have and what the assets of those clients total.
This market remains a decentralized or over-the-counter market. With myriad issues to choose from and with mammoth trading volume and institutional dominance, it becomes extremely important to select the right firm and then the right adviser. The choice of a firm must be made before you pick an adviser. Extra time spent on this decision can mean significantly enhanced returns and thus a higher standard of living and more comfortable retirement!
The first step is to determine whether an investment dealer or organization takes the retail fixed-income business and its participants seriously. Look for FIs who advertise a special focus on fixed-income needs. Develop basic questions to ask would-be financial advisors. Here are some common questions, as well as the answers you should be looking for.
Q: Is the retail fixed-income desk a captive of the wholesale desk or is it master of its own destiny?
A: To properly serve individual investors, the retail fixed-income desk should be focused on providing IAs and their clients with good advice and competitive pricing.
Q: Is it a stand-alone profit centre or is the desk’s compensation linked to the overall growth of the firm’s fixed-income business?
A: A desk that is motivated to grow the business of the IAs will offer the best overall service.
Q: What percentage of your business is fixed-income?
A: It should be in the 20 percent to 50 percent range.
Q: How is the Bank Rate set?
A: You should be told that it’s set at regularly scheduled meetings of the Bank of Canada (bankofcanada.ca).
Q: Assuming I have $100,000 in my RRSP, what kind of fixed-income portfolio would you recommend in individual securities?
A: IAs should mention stripped bonds (zero
