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	Bonds as a Long Term Investment Bonds are the most MIS-understood investment vehicle. The basic principle of long-term bonds is simple, but complexities of the bond market is what most people don’t get. The simplest bond model is a Government of Canada 30-year bond, known as a Canada long bond. The ones issued on January 1st, 2003 had a stated annual interest rate (or coupon rate) of 5.25%. The investor who purchased one of these $100,000 bonds will receive an interest payment of $2625 on June 30th, 2003, and again on December 31st, 2003. This will continue every six months thereafter for the next 30 years until December 31st, 2032. At that time the investor will get his or her last interest payment of $2625 and the original $100,000 back. This date is known as the bond maturity date. This is a straightforward concept. We know the federal government will always be able to pay the interest, and we know they’re good for the $100,000 at the end. However, in real life few investors hold onto a bond for 30 years, because there are factors affecting the value of the bond that causes investors to SELL. Remember - 30 years is a long time. Just like the stock market, there exists a bond market where bonds get traded in exactly the same way as stocks, with buyers and sellers for every type of bond. The factors that impact on the value of bonds are: The coupon rate of the bond, as it compares to the prevailing interest rates at that time, of bonds of similar lengths of time to maturity; and in WHICH direction bond traders anticipate rates are going. The rule is: "As interest rates go up, the value of bonds goes down" and vice versa. The quality of the issuer and their ability to pay not only the interest payments, but the principal at maturity. After all, when you give the bond issuer your money, ALL you’re getting in return is a piece of paper and a "promise" to pay. The promise is only as good as the issuer’s ability to pay. Remember - it’s not just the Government of Canada that issues 30-year bonds. Provinces, as well as cities, also issue bonds, as do most publicly traded companies. So the bond market is comparing the quality of the government of Canada’s bonds to the long bonds of the Governments of Mexico, Brazil, Argentina, etc. Or comparing the quality of bonds of the Royal Bank with that of Nortel or Enron. In Canada, the Dominion Bond Rating Service gives every bond issuer a rating based on their quality, and this rating effects the value of their bonds in the market. In the USA, its Moody’s, as well as S&P that do the ratings to tell investors what their promise is worth. The length of time remaining on a bond until it matures. Obviously, if a bond’s maturing in less than six months, and the issuer is solvent, then no investor is going to pay more than the maturity value of that bond since that’s all they’re going to get. However, if the bond doesn’t mature for 25 years, then a lot can happen over that time, and the other factors take over. Supply and demand for bonds and the direction in which money is flowing - either into stocks and out of bonds or vice versa. After the terrorism attacks of September 11th, 2001, the demand for quality long-term bonds soared as people bailed out of stocks. The supply of good quality long-term bonds wasn’t there, and as a result, their value soared even though prevailing interest rates in Canada and the US, were going down fast. Bond features attached to the actual bond. These features would be things like whether the bond is "callable", "retractable", "redeemable", etc.. These are conditions that the issuer puts on the bond when they issue them. For instance, "callable" means that the issuer reserves the right to "call" the bond back in at a stated time throughout the 30 years, and give the bondholder his or her money back. The issuer might do this if the going rates are a lot lower than what they’re paying on the bond. These features can have a huge affect on the bonds value. There is one measurement that sums up all of these factors into one calculation, and it’s used throughout the bond market to compare all types of bonds. This is known as the yield to maturity. It’s too complicated to try and explain how you calculate it, but suffice it to say it’s a function of all the above factors boiled down into one number. A good example of how bond traders use this to judge values would be a bond owned by a client of mine. She purchased a Province of PEI 30-year $100,000 bond with a coupon rate of 9.25%, issued on October 1st, 1992 and maturing Sept. 31, 2022. This bond was non-callable and non-retractable, meaning that the Government of PEI couldn’t call it in at anytime during the 30 years. Shortly after Sept. 11th, 2001, this bond’s value rallied so that the market was willing to pay my client $142,000 for her $100,000 bond. Someone was willing to give her $42,000 MORE than she paid, and they would receive in 21 years, just to get a 9.25% return on a quality long bond. At that price, at that time, it gave that bond an annual yield to maturity for that purchaser of 5.11%. Now, over two years later, the same PEI bond is trading at $134,000, as interest rates in Canada have bottomed out, and the demand for bonds since Sept. 11th, 2001, has gone down slightly. The annual yield to maturity for a potential buyer at this price is 5.46%. As bond prices go down, yields go up. The client never sold the bond. The bottom line on bonds: buy them when long-term interest rates have peaked and are on their way down. Sell them when long-term rates have bottomed out and are on their way up. Problem is, nobody can predict with any certainty what long-term interest rates are going to do. Cheers, Hugh
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