- Full Circle - September 11, 2023
- Yield To Maturity Might Be Indicating a Bottom in the Bond Market - August 21, 2023
- Reader Case: Nomadic Superfans! - August 7, 2023
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!
Conclusion
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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The question is, how does this benefit me if I hold these ETFs? Is it guaranteed that the value of the ETF goes up? Am I to expect a higher yield? If the weighed average yield to maturity is so high, why isn’t that translating into tasty profits in some shape or form?
Ditto!
That’s what should happen, yes. Day-to-day gyrations are always unpredictable, but if you hold the fund for the long term, you should see gains in the form of interest payments and capital gains as the underlying bonds mature and pay off.
Great explanation and 🥰 the rabbits.
Interesting ideas. Depends on your time frame. The chatter is that interest rates are not finished rising and they’ll ‘stay higher for longer’.
So I’m happy buying my CD, Money Market, GIC now at 5.8% without loss of principal.
Buying bonds now still have a massive risk of principal loss. That ‘capital gain’ portion may be a capital loss if the principal goes down. But if you keep for years I suppose it might gain maybe.
I’ll still with a guarantee CD/MM and with stocks going down broadly there will be
Cash to pounce on and get capital gains when stocks go up in the long run
Yep…totally agree. The pain ain’t over yet. I won’t be surprised to see 1yr CD’s breaking into the 6%, even tickling 7%, sometime in 2024…
…I’m happy with my crazy ridiculous ladder of 1yr CD’s.
Where are you getting CDs at 5.8%? Money markets are still paying 5% or so.
Vanguard currently has brokered CD’s at 5.6% (13~18 month). My speculation is that CD rates will break 6% sometime next year.
Although I agree that bond exposure is prudent, I’m wondering about all those who retired before 2022 with a 60/40 stock/bond portfolio that most financial advisors recommend…some might even be 50/50 or 40/60. Although the yield is still there, that’s gotta be painful !!
Agree . Basically bonds have lost big ly over the last year. That 60/40 is more like 60/20 with the other 20 disappeared for years
Bonds and stocks basically moved in unison in 2022, so allocation didn’t seem to matter much. Central banks giveth and central banks taketh away.
I do appreciate the insightful write-up.
A couple of questions:
(1) How does the preferred share market depend on the bond market?
(2) Have you taken into account that ZPR is down over 15% YoY and 25% over last 5 years?
Preferred shares (in Canada anyway) reset their interest rates according to the 5-year BoC yield, so their dividend yield should go up as interest rates rise. That being said, you’re right, they’ve been behaving quite irrationally lately because of fears of bank failures in the US are keeping prices depressed.
I think those fears are overblown and that this market is trading at a discount, but I acknowledge that’s an unpopular position to take right now. Hence why I don’t want people to necessarily follow me since I may be wrong.
Shouldn’t you be comparing this yield to maturity to the yield you get on newly issued bonds? Ex if you buy the 3.5% coupon bond that’s selling at a discount and giving you the 4.5% yield to maturity, wouldn’t it basically be the same thing as buying a newly issued bond at about 4.5%? Assuming the credit rating and time on these bonds are the same, they should have the same effective yield over time if bought now.
Or am I missing something?
Correct, more or less. Existing bonds with a built-in capital gain would be more tax efficient since a new bond paying 4.5% would be fully taxable interest income.
I stayed with it thanks to the rabbits, but I also learned a lot from your article in the meantime. You have a great way of explaining complexity.
Thanks! And always listen to bunnies, because bunnies know best!
Hop hop hop!
Dear Kristy, dear Bryce, this is the second time I have listened to Kristy’s book on audio and I am so grateful that you, Kristy, wrote it. It’s so motivating and positive. I also like the writing style and the clear words. If you are ever in Hamburg, Germany, I would be very happy if you would like to be my guests. Kind regards, Claudia, Hamburg
Thank you so much for the kind words! We visited Hamburg back in 2018 and we loved it! Next time we are in the are we will be sure to let you know!
For the most part right now many bondholders can get comparable returns relative to liquidity with brokerage money market funds. I bonds were outstanding last year but are starting to come back down.
That’s a good point. I think I should update the Investment Workshop to reflect this…
You explained it so well and easier to understand than some of the college professors.
Aww, thanks! My experience in university was mostly 1 hour of lecture followed by 5 hours of “What the hell did he just say?” so that means a lot 🙂
Wanderer,
You are indeed brave to call the bottom of the bond market. A couple points; first you refer to a bond yield to maturity and then talk of investing in bond funds. A bond matures and has a yield to maturity, a bond fund never matures so doesn’t have a yield to maturity. They are not the same.
As for how long high inflation will haunt us, my guess is we are in a long period of inflation above the Feds 2% target for three reasons:
First, in the United States we have millions of inflation innocents and actual inflation beneficiaries. When you are young, educated, earning in the top 25% ($80,000)1. in your prime your earnings years, watching your house goes up in value and repaying the mortgage in cheaper dollars each year you benefit from inflation.
We have millions of people who never experienced the inflationary mentality, buy now because it will only be more expensive tomorrow. Borrow if needed, but buy before it goes up in price more. We baby boomers have seen it devastate those whose income didn’t go up but whose cost of living continued to rise; retirees who couldn’t go back to work, lower paid workers who rent, and those on the dole with government benefits that don’t keep up with inflation.
Second, more people will start calculating what rate they need to get to not fall behind, and demand rates that give them a positive return.
For example if I invest in a 12 month certificate of deposit (CD) at 4.6%, will I have a positive return? I receive 4.6% interest, pay taxes state and federal in the 30% bracket, and pay inflation now 3.2%. So 4.6% – 30% = 3.2% – 3.2% = 0. I preserve my purchasing power and earn nothing.
(With this part of my investments I am not taking market risk so that at the end of a year I am guaranteed to get my money back. If I go for a higher yield on a bond or preferred stock I may or may not get all my money back in 12 months.)
Third, politicians are still getting elected by promising more inflation, promising to spend money the government doesn’t have. For a politician to promise inflationary policies in the 1980’s was political suicide.
My guess is that inflation will get worse and last longer than anyone expects. The trick is to have some investments that will prosper under that scenario.
1.
https://dqydj.com/income-percentile-calculator/#What%20Is%20Considered%20A%20Good%20Individual%20Income?
Boo307
August 22, 2023 at 10:17 am
Wanderer,
You are indeed brave to call the bottom of the bond market. A couple points; first you refer to a bond yield to maturity and then talk of investing in bond funds. A bond matures and has a yield to maturity, a bond fund never matures so doesn’t have a yield to maturity. They are not the same.
———
The above is a good point.
I went and took a look at the ZAG ETF which is comparable to VAB as I can view the tax distribution of the payments from it. Only in 2017 does it show a capital gain. In other words, you are gambling trying to score a capital gain from holding a bond ETF in a non-registered account. I hold all my bonds in my RRSP and LIRA while my tax effective investments sit in my non-registered account. The whole premise of this blog post is geared towards gamblers and specuvestors.
Very unfortunate.
For the other commenters who praised how well written this blog post was and what a great opportunity it is, you don’t have a clue what you’re talking about.
I’m just reading the metrics, man. You are free to disregard if you disagree, but metrics are metrics.
And I have read your blog posts from the time you started posting.
https://www.millennial-revolution.com/invest/workshop-invest/making-investments-tax-free/
The post just above makes perfect sense for a long term investor. Bonds belong in registered accounts unless you don’t have the room in there (which only applies to the uber wealthy).
Your current post is geared toward speculators and gamblers (ie clicks for advertising dollars). Nothing wrong with that. Nothing wrong with pointing it out either.
Correct, yield to maturity on a bond fund is the average of the underlying bonds’ YTM. That was a distinction that I didn’t address, as it added more confusion than it was worth it, so I left it out.
However, inflation has already come down quite sharply (on this side of the ocean anyway), so I’m not convinced of that argument. That being said, I completely agree with the point on so many people being inflation noobs and doing everything wrong, like going into massive debt to buy overpriced houses under the assumption that interest rates would never rise. Those people are being spanked, and I am totally ok with that.
So, if I followed along correctly, bunnies are nice and investing in bunnies is good. Got it!
Correct. Bunnies are nice AND adorable!
Hop hop hop!
Well if Elon Musk bought the company I wouldn’t be paying $100, but maybe $120. That guy is a genius and I love him even more now that he’s against the woke and a more of a conservative like me (and I’m a millennial, just not a stu-pid one)
Appreciate the post!