Making more money than many with bonds
January 25th, 2008 by moniesI find that most investors neglect their bonds, treasury bills or guaranteed certificates. They buy the first thing their broker recommends, and then hold it until maturity, at which time the process is repeated. It’s a passive and expensive approach that costs investors a lot of interest income waiting to be earned. It can also be dangerous if credit warnings are missed and supposedly defensive investments suddenly plummet in quality.
Now I am not suggesting for a moment that you should start speculating with your fixed income securities in order to achieve better results. As a rule this is money you can ill afford to lose or need to generate steady income. What I am proposing though is that you have a plan for your bonds, mortgages and certificates. Decide what you expect this part of the portfolio to achieve and then, within those parameters, make sure that the money is earning as much as possible.
For example, if you dare not risk these funds, restrict your investments to short-term government bonds. But be sure to monitor them closely for opportunities to switch into new issues with slightly longer terms to improve your yield.
Making Money with a Plan
1. Am I sitting on the sidelines holding bonds and treasury bills until the stock market improves and I can start buying Great Stocks again? If so, most of your holdings should be liquid, low risk investments such as treasury bills. However, have a time frame in mind because this is an extremely expensive posture. At present 30 day treasury bills yield 3% and are fully taxed, so they provide a net return of 1.5%. With the Canadian cost of living rising at 2.9% per annum you are losing money.
2. Are these funds needed to generate a reliable, regular income? In that event, opt for higher-coupon government bonds trading at close to par in order to reduce any premium or discount and optimize your cash flow. If more income is needed, replace shorter-term, say less than three-year government issues that now provide a 3.5% return, with senior six or seven-year corporate debentures, currently yielding about 5.5%. However, it’s a good idea always to buy corporate issues with DBRS A rating or better.
3. Do you intend to hold your bonds and certificates for the foreseeable future as a hedge to offset other, higher risk sectors of your portfolio? This is often the case for many conservative investors who are willing to commit some money to trusts and equities but wish to preserve a part of their capital.
So safety is paramount.
However, these fixed income securities are essentially long-term holdings and it’s important to ensure they earn the maximum amount of income consistent with their defensive role. This requires active management but fortunately there are some tactics that make the task easier.
Making More Money
1. New Issues
Have your broker or advisor keep a sharp look out for new bond issues that suit your needs. They invariably yield more than comparable bonds already trading in the market and the higher the yields, the greater the spread. This is because underwriters purchase large blocks of new bonds from the issuer and finance them at the bank. So in order to unload them quickly and reduce their interest charges, they price them below the current market bids. When interest rates are high there is even more incentive for dealers to sell the bonds quickly, so they offer larger discounts are offered.
Note that while all brokers have access to new issues, they don’t all have equal access. Brokers employed by dealers that engage in underwriting bond issues can bet bigger allotments.
2. Tax Implications
Potential returns and risk should always dictate your investment decisions. However, it’s a good idea also to keep an eye open for any tax breaks that may increase your net yield without adversely affecting the quality of your securities. For instance, if you are in a high income bracket, shop for deep discount bonds because only half the capital gain (the difference between your purchase price and par at maturity) is taken into your taxable income.
To illustrate, say interest rates climb from their present levels and you could purchase either of the following securities.
a. Government of Canada 6% bond at $100 due in 2010.
Your before-tax yield would be 6% or about 3% after-tax.
b. Government of Canada 5% bond at $93 due 2010. First calculate the after-tax interest income.
Then calculate the after-tax capital gain of $0.75. Note that $1 of the eventual $7 of capital gain is taken into income in each of the seven years remaining until maturity. But only half of that income is included as taxable income:
Author: Slee, Tom
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