At the beginning of 2023, I moved the fixed income portion (25%) of our portfolio to a Preferred Share Index tracked by the BMO Laddered Preferred Share Index ETF (ZPR.TO), and this might have seemed like a puzzling move at the time given that ZPR’s been all over the place this year. All that criticism is valid, and for the record, I am not officially recommending everyone follow along with us. Remember, there are 2 phases of the FIRE journey: Accumulation (building your FIRE portfolio) and Withdrawal (living off your FIRE portfolio). We are in the 2nd category and care more about dividend income than capital gains, so this move makes sense for us. If you’re still accumulating, stick with a plain vanilla bond fund.
That being said, I wanted to take a moment to talk about an interesting situation that’s been developing this year on the bond market, and why I think the entire fixed income world as a whole might be poised to start making some gains.
You’ve no doubt noticed that interest rates have gone straight up over the last year-and-a-half. Starting at the beginning of 2022, central banks in the USA and Canada jacked interest rates from near zero to about 5% for Canada and 5.5% for the USA. This resulted in turmoil in the housing market as mortgage rates got pulled up with it, and it also creamed the value of bonds. Miserable times were had by all.
Unfortunately, the pain in the mortgage market isn’t going anywhere. Holders of adjustable/variable rate mortgages on both sides of the border have already seen their payments spike, and over the next few years even holders of fixed rate mortgages up here in Canada are going to feel the pain when their mortgages renew, as we wrote about here.
However, an interesting scenario has developed in the bond market, and I think it might be forecasting that for investors, the pain in the bond market might be coming to an end, and the reason that I think that is because of something called Yield to Maturity.
Now, this is going to be a bit of a wonky topic, even for me. So I’m going to intersperse this article with pictures of adorable bunnies. Because who doesn’t love adorable bunnies?
What is Yield To Maturity
While metrics like distribution yield or 12-month trailing yield are relatively straightforward, yield to maturity is one of the more obscure metrics that you can find on a bond fund’s prospectus.
Basically, yield To maturity is a measure of how much return you can expect if you were to hold a bond to maturity. How is this different from the normal yield numbers? Normally, it’s not.
Imagine that you have a bond paying 5% interest that’s worth $100. You pay $100 to buy the bond. By holding it, you collect $5 every year in the form of interest, or coupon, payments. Then when the bond matures, you get your original $100 back. Your coupon yield would be 5%, and because you got your original investment back at the end of the bond’s term, your yield to maturity would also be 5%.
But what if you picked up that $100 bond for less than $100? Say, $90? Then you would get your $5 coupon payments like normal, but at then end of the bond’s term, you would get the bond’s par value ($100). But you only paid $90 to get it, so you’d make a profit on top of the interest. In this case, your yield-to-maturity would be higher than your yield, since you’d be making money on the interest, plus the capital gain at the end.
Yield to maturity for any bond can be calculated using a bond’s par or face value (the amount it pays back at maturity), its current trading price, its years to maturity, and its coupon rate. Here’s a handy calculator that does this, and if we put in our imaginary example from above, this bond trading at $90 with a par value of $100, a coupon of 5% and 10 years to maturity would give us a yield to maturity of 6.367%.
Why Bonds Get Discounted
Great Scott! Another way of making money? Why haven’t I talked about this before, you might ask?
Under normal circumstances, picking up bonds like this is a bit of a risky move.
Why would a bond with a par value of $100 be trading a $90? Under normal circumstances, it’s because that bond is seen as riskier than normal.
Let’s take a company ABC Corp that might issue bonds. They might be selling them at a certain coupon rate (say, 5%) for $100 at issue, and at the time, investors might be like “OK, that sounds reasonable. I’ll take it!”
Then Elon Musk buys the company, and does…whatever the Hell it is that he does. He lays off a bunch of workers, tears down the building, and renames it XXX because for some reason he really likes that letter. Would you still want that bond for $100?
Hell no, you’d say! That bond is a lot riskier now that he’s in charge, and if this company’s now stiffing their workers on their paychecks and their office landlord on rent, you probably have a lot more concerns about whether he’ll actually pay you what he promised. So you wouldn’t want to buy it for $100, but you might at $80.
This is what’s known as a discount bond. As the name implies, discounted bonds are being sold at a discount to its initially issued price, and usually it’s because the bond issuer is now seen as more risky than when it was initially sold. In other words, there are doubts about whether this bond will actually pay what they promised, and investors are demanding a lower price (and therefore a higher return) to account for this additional risk.
A discounted bond is easily recognizable because it’s yield-to-maturity is higher than it’s coupon rate because yield-to-maturity includes both the return from the bond’s coupon payments as well as the capital gain that the investor would get if/when the bond pays back the par value at the end of its term. So as you can see, investing in a discount bond is usually a bit of a risky bet because it’s not certain that the bond will actually do what it says it will do, and for that reason we don’t recommend our readers invest in these securities.
However, that’s under normal circumstances. We are not under normal circumstances.
Another reason that a bond can become discounted is when interest rates rise. This is because when central banks raise interest rates, that means that any new bonds being issued will be done at the new, higher coupon rate. When that happens, why would investors be interested in existing bonds that had been issued at the previous, lower rate? They wouldn’t. In order for those older bonds to be attractive to investors on the bond market, they also have to be discounted.
Only when this happens, it’s not because the bond has gotten riskier, it’s because the central bank interest rate has changed and better options are out there.
So that means right now, because interest rates rose so high and so suddenly, the entire bond market has become discounted, which you can now see yield metrics of popular bond index funds like the Vanguard Total Bond Index (BND).
You can see here that the fund’s yield to maturity is higher than its coupon, indicating there’s unrealized capital gains hidden in there.
You can also see this in the Canadian bond index tracked by VAB.
It’s extremely unusual for yield-to-maturity to be so much higher than it’s distribution yield on the entire bond market, and it means that if you were to simply buy and hold these funds, over the long term you would not only get the interest from the bonds themselves (distribution yield), you would also receive the capital gain as the bonds mature and pay back the original par value!
This effect is even more pronounced in the preferred share market, where the already impressive 6% dividend yield turns into an even more impressive 9% yield-to-maturity we should receive when the preferred shares mature and pay us a pretty sweet capital gain as well!
All this is my long-winded and wonky way of saying that while stocks have gained impressively over the year so far, bonds (and other fixed income instruments like preferred shares) appear to be sitting on the precipice of their own growth spurt as well.
And the really cool thing is that whether you stuck with the bond funds we recommend in our Investment Workshop (BND and VAB), or whether you own preferred shares like us, all of us stand to benefit in the coming years!
So what do you think? Do think you we’re approaching a bottom in the bond market? Or is there more room to fall? Let’s here it in the comments below!
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