New Investment – High Yield Bonds

[Edit] The following post was written in July 2014. I’ve posted an update in October about my purchased Sherritt Bonds. It’s not doing so well. [/edit]

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Investing in High Yield Bonds

Last year I blogged about wanting to invest in bonds as one of my goals because I’ve heard smart people invest in stocks, but smarter people invest in bonds 😉 Then earlier this month I wrote about taking out a loan and have dedicated some money to buy bonds with.

Well I have finally taken the plunge into bonds. Yesterday morning I purchased $5,000 face value of the Sherritt International Corporation 8% bonds, maturing on Nov 15, 2018, for the price of $104.475. I will explain the jargon in a moment, but essentially what this means is I have made an investment of roughly $5,200. And by the end of 2018 that investment will turn into $6,800. That represents a 6.8% annual return 😀 It’s not the best investment ever, but it sure beats the low returns on 5-year CDs and GICs.

Bonds are generally safer investments than stocks because if a business goes bankrupt bond holders have priority over shareholders 😛 muahaha. I’m not 100% sure on this so maybe Chuck the bond trader can weigh in, but I assume this means my 6.8% bond return is pretty much guaranteed as long as Sherritt stays in business until my bonds mature. Considering how the company’s stock is part of the S&P/TSX Composite index and it hasn’t missed a quarterly dividend payment in almost a decade, I think my 6.8% return is pretty safe 🙂

I will discuss three topics in today’s post: Why I’ve decided to buy these bonds. How to buy bonds. And what are the risks and expected returns of my new bonds.

Why Buy Bonds

6.8% return sounds great but I could have easily turned towards other investments that would probably generate 10% returns or greater. The problem is those higher return investments come with greater risk. About 90% of my liquid portfolio is already in the frothy stock market. Equity valuations are already quite high with the S&P500 at 18 times current earnings. So in order to manage risk I wanted to diversify my asset allocation and buy more fixed income assets, which are less volatile than stocks.

One option in the fixed income space is government bonds. However the returns on government debt are ridiculously low right now. Canada recently issued 50-year bonds with a 2.76% coupon, maturing in December 2064. Are you freaking kidding me? 🙄 lol. Will that even keep up with inflation over the next five decades? Why would anyone want to lock in an investment for 50 years that pays an interest rate of only a paltry 2.76%? Yet apparently Ottawa (Canada’s capital) said there was “exceptionally strong” demand in the market for it. Shows how much I know 😕 But if I want to retire in my thirties I have to look for bonds with higher yields than that.

So corporate bonds was the answer. Adding bonds into an investment portfolio can create stability and lower systemic risk. A bond’s face value doesn’t change over time. The global stock market could correct 50% but I would still get $5,000 back when my bond matures and not lose my principle. After looking through lists of available bonds to purchase I’ve decided to invest in Sherritt bonds which have a coupon of 8%. Sherritt is primarily a nickel mining company that has a credit rating just below investment grade status, which means its bonds are not completely immune to future events but its still relatively safe compared to junk bonds. It has the right balance of risk vs reward for me.

How to Buy Bonds

Before buying bonds you should understand what they are first. I’ve written a crash course on bonds last year if you need a refresher, or watch this informational video from Investopedia which explains how bonds work. Now that we understand that bonds are just glorified I.O.Us from companies that investors can make money from, let’s go find some bonds to buy.

Step 1: Find the bonds section in your brokerage account. In WebBroker click on the “Fixed Income” button on the left side of the screen. If you use another platform then it will probably be somewhat similar. If not, call and ask your broker about how to navigate to the bonds area.

Step 2: Choose a category of fixed income products. Government bonds are deemed to be safer but often pay lower interest. Corporate bonds are more risky but tend to have higher coupons. For the purpose of today’s post let’s select the “High Yield” category. A new window should pop up when you click any category.

Step 3: Let’s look at the list of high yield bonds in the new window. These are the current products being offered by your brokerage firm. Different brokers will have a different list of companies. The high yield bond market is not very liquid so availability is not universal. Let’s walk through each column so we understand what they all mean so we can make an informed decision on which one to buy. Spoiler alert, it’s the one highlighted in yellow 😛

• Issuer: The name of the company issuing (selling) the bond.
• Coupon: The annual interest rate an issuer pays to the bond holder (aka: the investor)
• Maturity: Date on which the annual interest payment ends and the principle of the bond is paid back to the investor.
• Worst Call Date: Some bonds are callable before they mature. This means the issuer can pay back the principle earlier to cease making further coupon payments.
• Ask Size: How much face value is outstanding.
• Ask Price: The premium or discount of the bond right now relative to its par value.
• YTW: Yield to Worst – The expected annual return when you buy it now if the bond gets called at the earliest date.
• YTM: Yield to Maturity – The expected annual return when you buy it now if the bond stays open to maturity.
• Ccy: Currency the bond is traded in.
• DBRS/S&P Ratings: A person’s credit worthiness is based on a credit score (FICO number) determined by Transunion or Equifax. Similarly a company’s ability to pay back a loan is determined by credit rating companies such as DBRS and S&P. Consumers receive credit scores, and companies receive letter grades.

Let’s pretend we want to buy a bond that matures before the end of 2018 because we don’t want to lock up our money for too long. Given that criteria we can ignore all the names below the red line I’ve drawn on the list. We probably also want a company to have a “BB” credit rating or higher because we don’t want to invest in a company that might not pay us back. Given this second criteria, it appears SHERRITT INTL CORP is the best choice because it meets both our criteria for a relatively safe bond, that is maturing within four years, and has a pretty attractive yield.

Step 4: Make the purchase. Call up your broker and tell them you want to buy the bond. 800-350-4832 if you use TD. Ask the representative any other questions you might have about the bond. When you’re ready to purchase just give them the name of the bond, maturity date, coupon, which account you want to hold it in, and of course how much you want to buy. The minimum investment amount for bonds is usually $5,000 of par value. Note that when you buy a bond over the phone the details may be a little different than what’s shown on the bond table you pulled up because the ask price and YTM changes throughout the day.

There you go. You can now be a professional bond trader 🙂

Risks and Expected Returns

This is my first time ever buying individual bonds so I have no idea what to expect or how things will turn out. All I know is Sherritt will pay me $200 twice a year (or $400 annually) which is the 8% coupon on $5,000 investment. The payment is interest income so I have this bond in my RRSP to minimize taxation. In November 2018 the bond will mature and $5,000 will be returned into my account. The 4.475% premium I paid for this bond reflects the commission cost and the current situation in the bond market. The sooner a bond matures, the lower the risk investors take on, so the lower the yield becomes. The 6.8% annual return I expect to make from this investment is derived by factoring in the premium I paid and the 8% coupon. I can sell this bond before it matures but my plan right now is to hold it until maturity.

Sherritt is publicly traded on the Toronto Stock Exchange and has a market cap of $1.3 billion. Most of it’s mining business is in Canada and Cuba. Its stock is trading at roughly $4.40 per share and is pretty much flat year over year, but most analysts are giving this stock a “buy” recommendation. DBRS defines BB companies as “speculative, non-investment-grade credit quality. The capacity for the payment of financial obligations is uncertain.” So there is some risk this company could default on it’s debt obligations before my bond matures but I think that risk is very small compared to the great return I’ll receive in the mean time. I don’t understand the bond market very well yet as I’m still very new to this asset class but maybe I’ll buy more bonds in the future when global interest rates are higher.

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Random Useless Fact: