Bondholders have security that is the envy of common stockholders. By law, bonds must have their coupons paid when due and their principal paid at maturity. Bonds issued by senior governments are always honoured. Corporate bonds, if in default, allow holders to seize the business, to the loss of shareholders. If bond investors seem kings of their castles, it is because, in fact, they are.

Status has a price, however. Bond and most fixed-income interest is taxed at the highest rate, as ordinary income. That makes bonds suitable for RRSPs, as taxes are not incurred until the money is withdrawn. Before the money is taken out, returns compound. For security and predictability, bonds and similar fixed-income devices make good
investments in registered plans.

Bonds sometimes are seen as paying less than stocks, but bond returns stack up pretty well compared with equity returns. For the 10 years ended Sept. 30, 2005, the SC universe bond total return index, which encompasses most of the Canadian bond market, produced an 8.2% average annual compound return. In the same period, the S&P/TSX composite index produced a 9.3% average annual compound return. Stocks beat bonds but, if the results are adjusted for risk, bonds actually come out ahead.

The investor who wants certainty and low risk will choose pure bonds issued by governments and investment-grade bonds issued by well-known names. The investor who wants to speculate can buy junk bonds with dubious credit ratings from small-fry companies and great companies fallen on hard times. Or they can buy credit card receivables with such shaky prospects that they are called “toxic waste” — or even high-yield foreign bonds issued by countries that have defaulted so often (think: Argentina) that an investor would be in the way of less harm in Las Vegas.

If you want to be certain of getting a known sum in a few years, nothing beats a
Government of Canada treasury bill or a Canada bond maturing in the time specified. There is certainty of payment in U.S. treasury bills, notes and bonds, and in other G-7 sovereign bonds.

Bondholders have less security when it comes to knowing what a bond will buy in 10 or 20 years. If inflation runs rampant, as it did from 1973 to 1982, bond prices can collapse.
Bonds with relatively low interest rates become less appealing than new bonds with higher coupons. Old bonds fall in price until their returns are competitive with newer, higher-paying issues.

The solution to inflation risk lies in Canada’s real-return bonds, U.S. bonds called Treasury inflation-protected securities and similar issues of major G-7 countries such as Britain and France. The concept is simple: the issues pay a base return plus an ongoing inflation adjustment. The adjustment boosts tax exposure, making RRBs and similar bonds best suited for RRSPs. For instance, a Canada RRB due Dec. 1, 2021, has a yield to maturity of 1.47%. A conventional Canada bond due March 15, 2021, yields 4.10% to maturity. The difference is the 2.63% cost of the RRB’s inflation protection. If inflation runs less than 2.63% on average in the next 16 years, however, the RRB holder would be better off owning the conventional bond.

Bond returns rise with risk. A highly rated Bell Canada due Dec. 15, 2009, pays 3.98% to maturity, while a worrisome GMAC Canada Corp. issue due Dec. 14, 2009, pays a tempting 9.49% to maturity for those who have no trouble sleeping.

Bonds crafted for small investors pay very poorly. This year’s Canada Savings Bonds will pay no more than 2% for the first year. CSBs are convenient and can be purchased on payroll savings plans. Compared with a 3.69% return to maturity on a Canada bond due Sept. 1, 2010, the CSB is rather unappealing. Financial institutions offer a little more.
The best deal at press time was 4.05% a year for five years on a GIC offered by Achieva Financial, a unit of Winnipeg’s Cambrian Credit Union. And deposits guaranteed by Canada Deposit Insurance Corp. beat CSB rates.

There are other ways to invest in fixed-income. Bond mutual funds, money market funds, global bond funds and exchange-traded funds invested in bonds provide professional asset-picking and efficient trading. The entry price can be hundreds of dollars rather than the multiples of thousands that are needed to trade negotiable bonds.

@page_break@The disadvantage of using mutual funds is their cost. The median MER on Canada bond funds is 2.01% a year, which is hefty considering that for the 10 years ended Sept. 1, 2005, investors in Canada bond funds received average annual total returns of 6.74% after those fees. MERs on money market funds had a median cost of 1.14% during the first nine months of 2005, a bit less than the 1.46% median net return to unitholders of those funds.

An alternative to holding bonds or high-cost bond funds is to invest in an ETF. For example, iUnits Government of Canada five-year Bond Fund, trading on the Toronto Stock Exchange (symbol: XGV), paces the return of the underlying five-year Canada bonds less a modest 0.25% MER. XGVs generated a yield of 4.55% for the 12 months ended Sept. 30, 2005, almost the 4.60% return of the SC short-term bond index for the period. The ETF provides bond exposure but never matures to face value, unlike real bonds that do revert to cash upon maturity.

Global bond funds provide exposure to debt financing that the private investor cannot get unless he or she has $1 million or more to fork over to a bond dealer. Investors in registered funds can have all the foreign exposure they want, now that RRSP foreign-content limits have been abolished. For the 10 years ended Sept. 30, 2005, foreign bond funds paid an average annual compound return of 3.42%, which is poor compared with what plain Canada bond funds paid. The underperformance is because of the recent rise of the loonie. Foreign bond portfolios make sense for people who plan to spend a lot of time wherever a portfolio is invested. But, for everyone else, foreign bonds remain currency speculation.

In an effort to make their products more appealing, fixed-income vendors have engineered stock indices into their GICs, and structured plays on domestic and global stock markets into notes that guarantee return of capital. Most work in this way: buy a mid- to long-term strip bond at a discount from matured value; invest the difference in an equity asset; and, when the strip matures, the original strip capital is paid at matured value even if the asset picked has been a bummer. Periodic redemption features can be worked in with a ladder of strips with various maturities or by writing covered calls on the stocks chosen for the at-risk portion of the deal.

Conventional bonds have risk embedded in their interest rates. But credit default swaps (CDSes, for short) can hold their value even if interest rates rise. CDS investors put money into a fund and receive insurance premiums from companies that have purchased default insurance. However, if defaults rise above a certain level and the fund has to cover them, the investor can be wiped out. A CDS from Toronto’s Connor Clark & Lunn produced a 5.41% return for 12 months ended Sept. 30, a superior return for fixed-income in a vehicle with a bit of distance from interest rate variations.

It is a way for bond investors to realize income, even when they are facing moderate rises in interest rates. But it is riskier than holding a government bond. In fixed-income, there are no free rides. IE