Friday, December 11, 2009

50%+ return, guaranteed... in ten years

Is it worth it to purchase an investment-grade bond that matures in December 2019, and pays 5.05% interest annually?

This is the question I faced recently. My advisor knew that I was interested in filling out the rungs on my bond ladder.

During a day of rising interest rates and hence falling bond prices he called to recommend taking a 5% holding in a single bond issue from a Canadian telecom company.

The bond is BBB with a stable or positive outlook. These companies have large subscription bases and steady cashflow. Default is unlikely or, more accurately, a very remote possibility.

So is this a wise investment?

Large money managers like pension funds and insurance companies love long-term returns in excess of 5% that are guaranteed because it makes covering their expenses infinitely easier.

Despite the difference in net-worth, the DIY investor faces a quality of life and peace of mind that comes from stable, guaranteed income that is similar to a profitable fund (manager).

While the large fund has pension benefits or liability claims that are often burdensome on the overall ability to create a profit, the DIY investor faces the many challenges of work, family, savings, trying to live and support a household, dealing with unexpected calamities, etc.

Both parties need stable income to overcome any ups and downs in the real world, and hence actually have a mutual affinity for the bond market and achieving yield in excess of the government benchmarks without being exposed to default risk.

But for the DIY investor like me, who has great bonds in the short and medium term and few bonds in the long term (5-10 years), I don't face the same pressures going forward that a large fund faces. I face the pressure of generating as much income from my employment as possible, protecting my savings from losing value, investing my savings in a way that will guarantee my principle contractually and include all interest payments.... that's all I need to be concerned with.

So this 10 year bond, 5.05% interest bond is sitting there, wondering if I'll put a relatively large sum of money in the company's hands for a full decade.

I decided to pass on the investment. While the cash is still sitting there perfectly safe and fresh and clean, it is not earning anything. I am ok with this. You can argue Canadian Dollars are worth 10% more now than they were a year ago, but that's not what we need to consider now)

Benchmark bond prices have suffered the occasional selloff and rally over the year and have provided some remarkable opportunities to make money using simple buy low sell high rules, trading the everyday bond issuers we see in Canada.

If this recent sell off is not part of a broader decline in bond prices, meaning inflation and/or market fears and debt fears are shaking, but not fundamentally shifting price support for bench mark bonds and industries and hence interest rates won't rise, I will have missed an opportunity. I will have missed at a chance to take advantage of a potential capital gains situation, or just simply enjoying a return that beats all the marketed products available.

If interest rates are really going up sooner and harder than we have expected, my money is now ready to be deployed to a medium term maturity and high interest rate, thanks to my ongoing study of the Canadian Bond Market.

If I had failed to study interest rate trends (once they hit bottom, they can only go up) and purchased a large bond issue right before interest rates start to rise, the value of my investment will be diminished. I'll likely never be able to sell without a loss before maturity because it will trade at less than 100 every day. To make it even worse, I wouldn't have as much money sitting around to purchase higher interest bearing bonds.

Be careful and remember: "he who fights and runs away, lives to fight another day"

No comments:

Post a Comment