UNDERSTANDING BONDS AND THE BASKIN FIXED INCOME POOL
Usually, when the stock market is having a bad period, as it certainly is now, investors can take some comfort in the fixed income part of their portfolio. They know that returns on fixed income are lower over time, but at least the capital is protected and yields are predictable. Usually. The last six months have seen the biggest drop in the bond market in history. In Europe, where government-issued debt has traded with yields at or below zero for the last three years, losses have been in the trillions of dollars (or Euros). In North America, losses have been on a smaller scale, but are still very substantial.
The cause is the rise in interest rates around the world. As central bankers look for ways to reduce inflation, which is running as high as 7% per year in some places, their first reaction is to raise interest rates. The hope is that higher interest rates will cool the real estate industry, lead to lower demand for consumer goods, and thus lower prices. As this chart of the interest rate on the 5-year US Treasury Bill shows, interest rates for five year money have gone from about 0.5% last August to 2.77% today. That is a very significant increase, particularly since the five-year Bill is a key benchmark for mortgages and consumer loans.
Many people find bonds confusing, and don’t really understand why they go up and down in value. They also are concerned that the Baskin Fixed Income Pool has lost some value so far in 2022.
In fact, the arithmetic involved is pretty simple, and some examples will demonstrate this. Please take a few minutes to follow along, and I promise that by the time you reach the end you will find that bonds are not really mysterious at all.
Imagine that your next-door neighbour Fred comes by your house and says “I need $100. Can you lend me the money for a year? I’ll pay you $2 of interest.” You trust Fred and agree to the deal. You are now the owner of a bond that has the following characteristics:
Issuer: Fred, high credit quality (Fred always pays his debts)
Face Amount: $100
Interest rate: 2%
Maturity: One year from today, April 25, 2023
That’s pretty much how all bonds are described, except you will sometimes see the description reduced to shortform like this, particularly in portfolio listings: FRED 4/25/23 2.00% $100.
The day after you have loaned the money to Fred, the Bank of Canada announces that it is increasing interest rates by 2% (how and why it might do this is another story). You are upset. You could go to Fred and say look, interest rates are now 4%, not 2%. Can we renegotiate? Fred will likely tell you a deal is a deal. So, you decide to sell your bond to your neighbour Sally across the street. You walk over and tell her you own $100 of FRED 4/25/23 2% bonds. Would she be interested in buying? Well, she says, sure, Fred is a great credit risk. I will be happy to pay you $98 for your bond. You are even more upset! You know, and Sally knows, that a year from now the bond will pay $100! Sally is asking for $2 for free, and you are looking at a 2% loss. Sally patiently explains that she can lend $100 to her buddy Cindy down the street at 4%, the new interest rate. A year from now she would have $104, a $4 profit. If she buys your FRED bond for $98, and gets $2 interest, she will also make $4. Either deal is the same for her.
You are grumpy and decide not to sell. A year later Fred gives you $102 consisting of the $100 you loaned him, plus $2 of interest as agreed. You didn’t lose money – in fact, you made $2 – but of course, had you been lucky and loaned Fred the money a day later, you would have made $4 instead of $2. What you did lose was opportunity, the chance to make a bigger profit. You console yourself with the fact that it was only one year, and now you can reinvest the $102 at 4%.
In the bond market, the day that interest rates went up, the value of the FRED bonds went down, in this case, by 2% to $98. If held in a brokerage account, the bonds would be “marked to market value” and would be shown with a market value of $98 instead of $100. Each day of the year, however, the bonds would be marked up a little bit as they got closer to maturity. Six months from issue, they would be worth $99, nine months from issue, $99.50, and finally, on maturity date, $100.
The three important points from this example:
- When interest rates rise, the market value of bonds fall.
- Market value does not mean you will not get paid the face value of the bond; it is simply what somebody will pay you for the bond today.
- The closer the bond gets to maturity, the closer its market value will get to face value.
Fred needs $1,000 to paint his house but knows he cannot afford to pay it back in one year. He comes over to visit and says, “If you loan me $1,000 for ten years, I will pay you interest of 5% per year, and the full $1,000 at the end of that ten years”. Now that you know bond language you know that you can describe this bond as FRED 4/25/32 5.00%. You feel that’s a pretty good deal. Short term bonds are paying only 4%, so Fred is giving you an extra 1% per year for loaning him the money for a long period. You make the deal. A week later, the Bank of Canada, fearing a recession, drops interest rates back to 2%.
Sally hears that you did a deal with Fred and comes to visit. She asks if you would like to sell your FRED 4/25/32 5% bonds. Naturally, you ask how much she is offering. Sally says “I could buy some other new 10-year bonds, but they only pay 3%, since the Bank of Canada dropped the rate. Your FRED bonds pay an extra 2% per year. On $1,000 that’s an extra $20 per year; over 10 years, that’s an extra $200. I guess I would pay you $1,200 for your ten-year 5% FREDs. I know that I will only get $1,000 when Fred pays them off, taking a $200 loss, but in the meantime I will get more interest each year than what I would get on a new bond.*
You are thrilled with the idea of making a fast $200 profit – 20% on your $1,000 investment – but then you think about it and realize that you will now have to reinvest that $1,000 in a bond that is paying only 3% instead of the 5% you are getting from Fred. Should you trade the extra $20/year for a fast $200 now? You also recognize that if you don’t sell, the value of the FREDs in your portfolio will be “marked to market” and the $1,000 bond will have a market value of $1,200. It’s not money in your pocket, but it sure looks nice!
These two examples illustrate, in simplified form, how the bond market works. When interest rates go up, the value of existing bonds are marked down, since the holder loses the opportunity to invest in higher paying bonds. When interest rates go down, the value of existing bonds are marked up, since they now offer a higher yield than is available on newly issued bonds. These changes in market value happen even if the holder has no intention of selling the bonds, but the changes in value are only realized if the bond is sold. Finally, the time to maturity has a drastic effect on market value. On the one-year FRED bonds, a 2% change in interest rates only caused the bond to drop in value by 2%. On the ten-year FRED bonds, a 2% change caused the market value to jump by 20%. The longer the time to maturity, the more sensitive a bond is to changes in interest rates.
In our Baskin Fixed Income Pool we hold all bonds we buy to maturity. The bonds are marked to market once a week, and at month end. The market value does not, of course reflect what the pool will get when each bond matures. In times of rising rates, the market values prior to maturity will always be less than the maturity values. Recognizing the significant impact of longer maturities on rising rates, we have kept the average maturity to under four years, about three years less than the bond market index. This has greatly reduced the drop in market value during this period of rising rates and has accelerated our opportunity to buy new, higher yielding bonds as the older ones mature and are redeemed at 100 cents on the dollar. (We have never suffered a loss of principal or a default in interest payments). We also hold in the Pool some securities that are at floating rates; the interest paid on these instruments rises and falls with market interest rates, protecting capital values.
As a result of our decision to keep rates short, not trade into the market, and due to our investment in floating rate securities, our Fixed Income Pool has outperformed the Canadian Aggregate Bond Index by a wide margin. As of April 30, the Index is down by 9.4% for the year to date. Our Pool, taking the distribution of $0.11 on March 31st into account, is down only 5.0%.
We recognize that our investors view the Fixed Income Pool as a conservative store of value that is less risky than the stock market. Any drop in value for the Pool is unwelcome and somewhat disturbing. However, during the worst bond market fall in history, our clients have lost a minimal amount based on “mark to market” valuation. Not what we had hoped for, but in fact, a very strong result. The Pool is doing its job.
*Strictly for math nerds. The actual value of the 10-year FREDs after interest rates have gone down is not $1,200, but $1,170.60. This is because Sally does not receive the $200 of interest at the end of the ten years, but at the rate of $50/year for the period. She has the opportunity to reinvest each of the periodic interest payments as they are received. This reduces the effective duration of the bond. If the $200 of interest was all payable at the end of the period, the duration would be the same as the time to maturity. Lower duration reduces the impact of a change in interest rates. In this case, the value of the ten year FREDs actual rise by only 17%, not the fully 20%.
Chairman, David Baskin
An Ernest Opinion
Barry Schwartz on BNN The Street – April 19, 2022
- Buckets of companies to own during high inflation periods
- There will always be an unprecedented event