Where does a newbie start to invest?
Another investment to know about: Bonds
If you read the first part of this series here where I talked about savings accounts or the second part where I talked about GIC's you would know what I consider to be a couple of the easiest ways to start investing.
Where does a new investor go to look after this? My first thought would be ETFs. However, that's a big topic and since I've been talking about fixed income investments so far (Savings account and GIC) I suppose I'll continue with the "big boy" fixed income investment.
# Bonds
Of course a disclaimer first. I'm not a financial advisor, I'm just a guy who likes investing and giving people a bit of information before they talk to an actual financial advisor. Use this information accordingly. Having said that bonds are not newbie friendly. I say this for a few reasons and the main ones are:
- They require a large sum of money
- They require an investment brokerage account
- Their pricing isn't as straightforward as GIC's and savings accounts
- They are not insured and some are riskier than others
- They have a cost to buy, a cost to sell, and sometimes it can be slow to sell.
To make it even more confusing some financial products are actually Bond funds and not individual bonds themselves. They behave in a different way than holding the bond and while they share the same underlying asset they are absolutely not the same thing.
They require a large sum of money
When governments, municipalities, provinces and corporations want to borrow money the will often look to the bond market so that individuals and institutions can fund their borrowing needs. They create a debt instrument (bond) which stipulates the purchase price, the interest, and the date on which the investment is returned.
With my brokerage account I only see bonds starting with a $5,000 minimum. The bond may be $1,000 denomination but I see the minimum 5. In addition bonds can be other denominations like $100,000. I can say I've never looked at those ones :)
Most newbie investors aren't looking to drop $5,000 on a single issuer. That's why I mention they aren't the most friendly for someone starting out.
They require an investment brokerage account
Okay require might be a little strong. I do remember a time when you could walk into a bank and buy Government of Canada savings bonds from them over the counter. I haven't seen them being offered for a very very long time. I would hazard a guess that the vast majority of bonds are bought and sold on the bond market. To access the bond market you will need a trading account. At least in Canada, I won't say for other countries.
Setting up an investment account isn't difficult but it certainly does require a fair amount of paperwork. There are many forms to sign. Simple things like information on the investor, tax forms, know your client forms, risk assessment forms, investment knowledge forms and so on. Similar to the forms required to buy a GIC (or savings account) but much more details required.
There are fees involved
Guess what. Brokerage accounts have fees. I deal with a major Canadian bank that advertises "A buck a bond" which sounds cheap. Then read the fine print. Bonds are denominated in $1000 denominations and a minimum purchase of $5000. So my $1 turns into $5, still cheap. But there is a minimum $24.99 fee to buy a bond. Really?? that means unless I'm buying $25,000 in a bond I'm paying more than a buck a bond. Plus $25,000 isn't really newbie friendly. Then another gotcha is "add $50 for telephone service so if you want to talk to someone to make the trade you are paying a minimum $75!!
At that point why not save a bunch of money in fees and buy a GIC instead.
Well, bonds do have one feature available that GIC's do not. A bond can be sold while a GIC you are locked in until the expiry date. That is a huge difference. In my account I actually have a couple of bonds. The bonds I have pay a fixed rate of interest for the next 28 years! That's great for knowing I have regular income from them for what is essentially my lifetime. If I couldn't sell the bonds that means I would be stuck with that bond potentially for years after my death. Good think they can be resold....provided you pay the fees of course :(
Some bonds are riskier than others
Let me ask you a question. Which is the riskier option? The Government of Canada debt of the Government of the United States debt? I don't need to know the answer but I bet you would choose one to be riskier than the other. Different risk, different interest rate.
How about a different question. Is the Bank of Canada more likely to not pay its debts over the next year or over the next 30 years? I would guess that the one year chance of repayment is very high. The 30 year is also very high but then again a lot can happen in 30 years! Longer terms are riskier and typically get higher interest rates.
And another question. Which is better able to pay their debt? The Government of Canada which prints money or a big company which has to earn it? Governments can print more money to cover debt or they can restructure it but there are risks. If it prints too much it may not be worth much leading to inflation. Companies (Corporations) can't print money, they have to earn it. If they can't pay their debt bankruptcy is often the recourse and a bankrupt company doesn't usually pay back bond holders in full. Again corporate debt usually pays higher interest because it is typically riskier.
This matters. Unlike GIC's and Savings Accounts which are typically insured, bonds are not. When Washington Mutual bank went bankrupt? My account was frozen on the Friday and I had a Chase bank account on Tuesday. Sure my money was unavailable for a few days but my money was safe. If I had Washington Mutual Bonds? I'd be part of a bankruptcy court action deal for a long time and likely only get a portion of my money back. I know which scenario is easier to deal with.
Their pricing isn't straightforward
Here is something that many people have trouble wrapping their mind around. A $5,000 bond typically doesn't cost $5000. It can cost more or less than $5,000. Perhaps if you get the bond directly from the issuer on its initial issue date but I bet even then there are issuing incentives or bank fees that make the $5,000 different than stated.
However, for the average personal investor using an investing account? Things are rarely 1:1 and there is a bunch of math involved. Personally I like math and understand the pricing. For many people the math just gets confusing but here is an example.
Let's dissect this a little bit.
I have a Province of British Columbia bond
The bond when issued was:
$ 6,000 to buy
Paying 2.8% interest
every three months (quarterly)
Until June 18, 2048
when they give $ 6,000 back.
Except right now I can get a GIC which pays higher interest 3.5% for a shorter term 5 years with no fees and less paperwork. Why would I ever want to buy something that is more work and lower return? It doesn't make any sense at all.
Unless someone lowers the price
In this case they lowered the price to $72.393 per $100. If I get a 27.6% discount? Then I'm getting 4.843% return paid out quarterly for the next 22 years. That sounds a lot more interesting than a 3.5% GIC.
Now if you look at the top line you will notice that currently this bond is worth $289.17 less than when I bought it. I could sell it today but I would be taking a loss both on the price I would get and on the fees I had to pay. Absolutely not a good time to sell. Especially since it is still paying me every three months and I'm still virtually guaranteed to get $6,000 when its time is up.
Don't worry if you didn't catch all that math.
The point I was trying to make is that the pricing of bonds isn't nearly as straightforward as it is for GIC's (or savings accounts).
I'll stick to my original claim. Bonds are useful financial investments but they aren't well suited to individual investors.
and I will very briefly talk about bond funds and ETF's before I close and why they are different than just buying and holding yourself.
and just for fun there is another type of bond to make the math more interesting
Strip bonds.
If you look at the bond example above you will see that I pay money up front and get income regularly and then a fixed payment at a future date.
What if I didn't get the monthly payments?
There are bonds called strip bonds where someone else claims the interest payments and sells the face value at a future date. In my case it is $6,000 on June 18, 2046. Hmm... What if it was June 18, 2043. What if someone had a brand new baby? If the bond was purchased today it would give the baby $6,000 when they are likely to finish high school. A kind of cool gift for a grandparent to buy for the child.
The strip bonds are actually quite cheap if you compare purchase price and maturity price. I haven't looked up strip bonds recently but $2,000 today for $6,000 in the future. Or perhaps you want to put in money now and know exactly how much you will have on the date you retire. They are niche but they are out there. Not something I'd readily recommend to a new investor but absolutely a cool tool to have in your financial toolkit and at least be aware of.
Bond funds
When I buy a bond I can hold it until its maturity date and know exactly how much money I will get. I will get reliable income until that date so I can count on it almost like clockwork.
If you purchase a bond fund? In that case a portfolio manager will be buying and selling bonds. The bonds will go up and down in value depending on the interest rates and sometimes they take a loss and sometimes they get a gain. The issue is that because the bonds may not be held to maturity there is additional risk. The bond I have I have a guarantee of $6,000 at the end. In a fund? Perhaps the manager sells at a loss now and once sold the loss is locked in.
I'm not saying that bonds funds are bad. Far from it, they give regular income and the underlying investments are actually quite strong. If you happen to know that interest rates are going to go down they often give very good returns. Unfortunately if interest rates go up they tend to go down in value. Figuring out when to buy and when to sell, or when to just buy and hold....that's why you want a good financial advisor.
So why bother mentioning them?
I actually do like bonds. When held to maturity they are usually very reliable. Fixed income for a fixed time for a fixed price. When I look at bonds like the one I hold and compare to getting an annuity for retirement I'll likely hold the bond most of the time. More on that in a later post though.
When personally held to maturity they aren't difficult to understand. Yes there is math and yes there are fees but if I consider a $25 fee spread out over the next 25 years it doesn't seem so bad. If I buy and hold it can make a lot of sense. The $5,000 hurdle does make new investors think twice though. When dealing with bond funds? The individual bonds may never reach maturity and that introduced more uncertainty on yields.
End of the day? I think its great to know about bonds. There may be a time when they make a lot of sense to purchase but not usually for new investors.
As I finish up I'd like to say thank you for reading down this far. If you have comments or questions I'd love to hear them. If I goofed on math or details, yeah, I should probably hear that too. Otherwise I hope you learned something and found this useful. Thanks again for reading.