The Vault
Whether rates are up or down, fixed-income makes sense

by Graham Barber

Interest-rates today are at historical lows. This consensus view is that rates may soon start to rise - first in the U.S. and then in Canada. This presents both challenges and opportunities for fixed-income investors.

On the one hand, when interest rates rise, bond prices and prices of bond mutual funds typically follow. On the other hand, higher interest rates mean that investors will be able to earn better yields on Guaranteed Investment Certificates (GICs) and other fixed-income products.

Whatever way interest rates are headed, most of us could benefit from holding some fixed-income investments. When held over the longer term, bonds, GICs, and bond funds add balance and stability to an investment portfolio.

The fixed-income universe: What you need to know

Most investors understand the importance of diversifying their portfolios by asset classes, geographic region, and market sector. Diversification is one of the best ways to reduce market volatility and increase potential returns.

There are also a number of ways to diversify the fixed-income portion of your portfolio. The choices that are right for you will depend on your goals and investment experience.

Government bonds

When you buy a bond, you lend money to a borrower who agrees to repay you that money on a certain date, along with a set rate of interest for its use. Benchmark government bonds are typically the most secure.

In Canada, the benchmark is the 10-year Government of Canada bond. If you were to buy a newly issued benchmark bond and hold it until maturity, your yield and capital would be guaranteed.

Provinces and municipalities also offer bonds; the yields offered by these bonds are typically higher than the yield on the benchmark Government of Canada bonds.

Corporate bonds

These bonds can also provide higher yields than government bonds, but they come with a greater risk. The outlook for the company, the sector in which it operates, and the economy can all influence corporate bond prices.

When the outlook for the markets and the economy are improving, corporate binds tend to outperform government bonds.

However, government bonds often outperform corporate bonds in times of uncertainty, as investors move into safer investments. Indeed, we saw this a few years ago when the stock markets were going through some tough times.

How to take part

To buy government or corporate bonds directly, you would need a brokerage account (self-directed or full service). For mutual fund investors, bond funds typically hold both government and corporate bonds in their portfolios.

Bond mutual funds

Many investors choose bond funds for the fixedincome portions of their portfolios. Funds provide instant diversification and access to professional expertise, as money managers choose the individual bonds and their terms. Purchasing a bond fund is easy to do, and you have convenient access to your money if you need it.

Fund Tip: Not all bond funds come with the same risk profile. More volatile returns may indicate that the fund includes riskier assets, including lower-grade bonds. A bond mutual fund that holds longer-term bonds (maturities of more than five years) will have a more volatile unit price and return than a short-term bond fund. This is because longer-term bond prices typically fluctuate more than shortterm bonds.

For most of us, the fixedincome portion of our portfolios is meant to provide stability, and the funds you choose should reflect this goal.

Strip bonds

These bonds are created from existing government of corporate bonds that have been stripped into their main components - interest payments and principal - and then sold separately.

Unlike a typical government bond, strips do not pay regular interest. Instead, they are sold at a discount to their face value. For example, let's say that you purchase the principal on a five-year bond with a face value of $5000. That strip may cost you, say, $4000, but at the end of five years, you will receive $5000.

Since there are no interest payouts to reinvest, strip bonds are ideal for investors with a longer-term horizon and who don't require regular income. This makes them a good choice for registered savings plans, but you need a brokerage account to hold strips.

Longer-term GICs

As with a government bond held to maturity, the interest and principal on a GIC are guaranteed if held for the term. The longer the term of the GIC, the better the rate. One of the other main benefits of a GIC is that it is very easy to purchase.

Some tried and true strategies

The buy-and-hold approach and a "laddered" strategy are two of the most common ways to hold fixed income investments.

Buy-and-hold

You select a bond or long-term GIC, hold it until maturity, and collect the regular interest payments. This strategy can help ensure capital preservation and a steady stream of income.

The main risk to this approach is that interest rates might rise. If you bought a newly issued fiveyear government bond and rates then rose, you would be left holding an investment that pays less than the going market rate.

Laddering

To protect against the risk of rising rates, you might considering staggering or laddering the maturities of your fixedincome investments.

So, instead of investing, say $25,000 in one 5-year GIC, you could invest $5000 in five GICs that mature over one, two, three, four, and five years. When each GIC matures, it would then be rolled over into a new five-year product at the best available rate.

All investors can benefit from the stabilizing role of fixed-income investments. Your advisor or broker can help you decide on the investment choices that are right for you, based on your goals and time horizon.

The proceeding information was provided by Graham Barber, Branch Manager of Scotiabank, Alcona Branch. The Scotiabank, Alcona Branch, is located at 1161 Innisfil Beach Road, (705) 431-6116.

The Vault is a weekly series of articles provided by Graham Barber with financial advice and suggestions.