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Investing in bonds 101 Bonds can prove to be risky in the near future nvesting in the safety of bonds could prove to be risky business during the next several years. Investors are encouraged to plan a cautious investment strategy. Bonds are appealing to those who have become discouraged by poor stock market returns and to those who are fearful that the European financial crisis might cause further damage to global stock markets. Our recommendation is to understand how bonds work in order to know the risks, so you can plan your bond strategy accordingly. A bond is a loan taken by a company or government that pays interest to you, the lender. You receive interest income each year and at the end of the term of the bond, you are re-paid the loan amount assuming there is no default. For example, you purchase a Government of Canada bond that matures in 20 years. Every year you hold that bond, the federal government is obligated to pay you a specified amount of interest at a specified interval. This is perfect for those who want to receive income for the next 20 years. TWO OPTIONS There are two options: you can hold the bond for the full 20 years or you can sell it anytime prior to maturity. Similar to other types of investments, the value of bonds rises and falls due to normal trading activity. Today there are significant risks that the value of bonds will decline. The value of bonds is largely dependent on prevailing interest rates. Here is how it works. Assume your Government of Canada 20-year bond pays four per cent interest. If interest rates rise to say six per cent then new bonds being sold will pay a higher interest rate than your bond, 13 · Thursday, June 14, 2012 OAKVILLE BEAVER · www.insideHALTON.com I so these newly issued bonds will be more attractive to investors. The result is your bond will decrease in value. The more interest rates rise, the less attractive your bond is and the more your bond price will decline. Why? at an historic low. Rates will likely increase over the coming years and the only thing to be determined is when and by how much? These two factors will influence the amount of decline in the value of bonds. Dollars & Sense By Peter Watson "When investing in bonds... understand your options and the risks those options face." Because in order for you to sell your bond you have to make the purchaser not see any benefit of buying a new bond maturing at the same time as yours. This is achieved by the price of your bond declining so that the interest payment -- although still at a four per cent payment based on the original purchase price -- is now producing a six per cent return to the purchaser since they paid a lower price for your bond. If you hold your bond until maturity then you will receive the full amount of the bond. However, during the time of ownership the bond would have to be sold at a discount to compete with new bonds at their higher rate of interest. The reverse is also true -- when interest rates decline the value of existing bonds increase because they are preferred over new bonds that pay a lower interest rate. DECLINING INTEREST RATES MAKE BONDS MORE ATTRACTIVE That is why bonds have been particularly attractive for the last few decades as interest rates have declined significantly. But that was then. Current interest rates are There is another significant risk factor. Term, the period of time until your bond matures, is a big driver of bond volatility. If your bond matures in 20 years, there will likely be a much larger decline than if your bond was maturing in say one or two years. The longer you have to live with a lower interest rate, the more the value of that bond will decline. BOND INVESTMENT STRATEGIES There are several bond investment strategies you could follow. Keep the maturity dates of bonds relatively short. Those bonds will decline in value less than their counterparts that have a longer term. We have only given a basic scenario and there are a number of other factors and risks that affect bond prices, which we haven't touched upon here. When investing in bonds, it is important to understand your options and the risks those options face. Then make your investment decisions based on your specific financial needs. -- Submitted by Peter Watson, MBA, CFP, R.F.P., CIM, FCSI.