Thursday, October 1, 2009


So if you like what you hear about guaranteeing the return of your principal and a 7% return, why not move more money into bonds.

This article will provide a brief overview of all the basics.

However, it's written for an American audience and I think there are a few important things to ignore:

1) ignore anything related to municipal bonds and professional management, the market place and advisors typically work in a different fashion in Canada with respect to the bond market

2) ignore the section which tells you that a minimum of $100 000 is needed in order to safely purchase individual bonds.

The reason for number one is simple: the tax codes are different in Canada and the US for municipal bonds- they are usually exempt from many taxes in the US.

As well, because the Canadian bond market is dominated by a small handful of financial institutions, the fee structure typically works differently for professional management. You typically pay a hidden fee that is included in the final price you pay per bond.

The reason for number two is the purpose of this post. If you pay attention to what I've written about here and here, I believe it is possible to safely purchase and invest individual investment grade corporate bonds in units as small as $5 000 for the individual DIY investor, using a discount brokerage.

The investor starting with approximately $5 000 - 50 000 dollars to invest in fixed-income will have two distinct advantages over any bond fund currently available in Canada

1) There are no bond funds which come with a guarantee to repay your principal by a specified date- this is a very important distinction if security, preservation of capital and the ability to sleep at night are a high priority for the investor (which they always should be, no matter how young).

2) Through careful and deliberate purchases of individual bonds (filling up one rung of the ladder each time you have new monies to invest), the overall performance of the investor's fixed income portfolio will exceed the yield offered by any bond fund by about 1%, or 100 basis points.

Number one is straight-forward, number two is a little more complicated but can be easily summarized:

1) Bond funds typically promote their suitability to retail investors because of their size, and their ability to diversify among issuers and therefore eliminate any credit risk or exposure to interest rate/inflation pressures. While this is generally correct, I've repeatedly made the case that laddering a portfolio of individual bonds can achieve the same effect.

2) Because bond funds are so large and because they are compelled to buy and sell more and more bonds, if not own all the bonds in the market (like some etfs), they always carry a large amount of bonds that are among the safest and therefore lowest yielding while incurring costs that are eventually passed on to investors, further diminishing yield.

3) The individual bond investor can safely ignore the lowest returning bonds in favour of lower-rated, but still financially stable (BBB investment-grade rated or above) corporations. Using a discount brokerage can reduce management fees to approximately 0.01 – 0.05% of your assets each year. It's simply not possible or worth your time to get high quality investments for less in any marketplace. The net result is a total higher yield for the DIY investor who chooses to ignore bond funds and engage in the often difficult and obscure task of building a rock-solid bond portfolio