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How long? How
good?
Some bonds are safer than others.
The safer they are, the lower the interest rate
you'll earn. Again, the longer they have to go
to maturity, the higher the interest rate may
be. The financial world talks about short, intermediate
and longterm bonds. So you can sound like a pro
the next time you discuss bonds with your financial
advisor, you should know that generally speaking,
short-term is considered less than five years,
intermediate five to seven years and long term
over seven years. For truly short term investments
of less than a year, consider deposit certificates
available through your bank.
All levels of government offer
bonds and they usually pay lower interest rates
than corporate bonds because they're safer. Still,
some provinces have better bond ratings than others.
Always check ratings before you lay your money
down.
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Every doctor's good portfolio deserves
bonds, yet many of your colleagues are fuzzy on what
they are and how they work. Financial advisors often
recommend them in the interest of a 'balanced' portfolio.
In theory, they're less volatile than stocks.
The first part of "what they are"
is relatively easy: a bond is a loan you make to a government
or corporation which pays a set amount of interest annually
until a pre-determined 'maturity' date at which the
principal is repaid.
Here are a few terms that will
help you understand bonds better:
Maturity date This is the
date at which the amount of the loan — the face
value or principal — will be repaid
The face value (also called
the par value) This is the amount you'll receive at
the maturity date.
The coupon rate This is
the interest rate the bond carries. It's an annual rate
but is generally paid twice a year. Usually, though
not always, the farther off the maturity date is, the
higher the interest rate. A bond that matures in five
years might carry an interest rate of 5%; one that matures
in 10 years might pay 6% in annual interest.
BOND
TYPES
There are different types of bonds. A typical $1,000
bond might have a maturity date in 10 years and a coupon
or interest rate of 6% a year. As the bondholder, you'd
receive $60 a year in interest paid in two installments
of $30 each. On the maturity date in, say, 2016, you'd
be repaid the $1,000.
A "callable" bond, on the other
hand, has periods before the maturity date at which
the institution that issued the bond has the option
to pay the bondholders off. This could be a disadvantage
to you if interest rates fell below that carried by
the bond and it was "called." As the bondholder you'd
be paid off but might have trouble finding as good a
return since prevailing interest rates were lower than
they had been at the time you purchased the bond.
Then there are strip bonds. Strip
bonds are where much of the confusion about bonds originates.
Strip bonds carry no interest rate and, instead, are
sold at a discount lower than the face value. For example
a 10-year strip bond with a face value of $1,000 might
sell for around $560 when it was first issued. You'd
buy it for $560 today and cash it in on the maturity
date 10 years from now and receive the face value of
$1,000.
You have to pay taxes on a bond's
earnings unless it's in your RRSP or other deferred
plan. Bonds are sometimes used to fund a child's education.
For example you could purchase a strip bond that matures
at a time that the child begins to attend university.
If it's put in the child's name the taxes on the bond's
earnings might be low or non-existent depending on the
child's annual income.
WHAT
DO BONDS PAY?
How much a bond pays, commonly called the yield, depends
on two things: prevailing interest rates and the rating
of the bond. Bonds are rated by two companies in the
US, Moody's and Standard and Poor's (S&P). S&P's
ratings use letters only and begin with triple A (AAA),
the highest rating and go down from there to AA+, AA,
AA-, A+ and so on. Investment grade ratings are those
at BBB- and above. Speculative or "high yield" rankings
begin at BB+ and work their way down to C, a so-called
"junk" bond of such high risk it's unlikely anyone would
buy except at an enormous interest rate.
Moody's ratings begin at Aaa and
then descend through Aa1 to Baa for investment grades.
Speculative bonds begin at Ba1 and descend to a lowly
C1.
Clear so far? Here's the part where
many investors begin to get confused: strip bond prices
have an inverse relationship to interest rates. When
interest rates go up, bond prices drop. Why? Because
when you buy a bond you're actually purchasing the right
to a certain amount of money in the future — the
face value of the bond. When interest rates go up you
expect to receive a high return on your investment so
you'll want to pay less for that bond that's going to
be worth a set amount in the future.
There is a quick way get an idea
of how much you may gain or lose when interest rates
fluctuate. The rule of thumb is to multiply the change
in interest rates by the time left to the bond's maturity.
For example if interest rates drop 1% and you've got
five years to go to maturity, the bond's value will
drop by 5%.
Here's another twist. Bond issues
that are in high demand are often sold at a premium,
particularly short-term bonds (less than five years
to maturity) so you must take care to see that the face
value and the interest you're likely to earn will cover
the premium.
Bond funds are popular with many
physicians. They're just like mutual funds except they
invest in bonds instead of stocks. One of the reasons
to include bonds in your portfolio is to give it some
stability against the vagaries of the stock market.
Under normal circumstance, they'll do that. It's wise
to remember, however, that even bond funds can lose
money if they're not prudently managed.
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PHYSICIAN LIFE
