Knowledge Center

A rabbi went to a financial advisor and said, “Teach me about bonds while I stand on one foot.” The wise advisor said, “If the credit quality is high the risk is low; if the duration is long, the risk is high. The rest is commentary; go and learn it.”

By David Baskin, Chair, RPB Board of Trustees

For most retirement plan participants, how to split (or allocate) their investments between stocks and bonds is an important decision. Investors correctly view stocks as riskier and providing higher returns over time, and bonds as safer, but typically with lower returns.

Why do bonds behave this way?

Let’s start with the basics. In simple terms a bond is a promise by a borrower to repay a lender a specific amount of money on a specific future date, with added interest. The borrower can be a government, a company, or a person. The lender, who is the owner of the bond, might be a retirement plan, a bank, or an individual.

Before we get into more detail, I want to note that RPB participants don’t need to research or evaluate the kind of individual bonds I’ll be discussing here. The bond funds in RPB’s investment lineup own a variety of bonds that share certain characteristics, and our plan gives investors a range of ways to invest in bonds, depending on their individual needs.

BOND BASICS

Any bond has only three things you need to know about it:

1. The borrower. This is most important, because the ability and willingness of the borrower (also called the issuer of the bond) to pay back the lender (the bond buyer) on time determines the credit quality of the bond.

The highest quality bonds are issued by the government, followed by major banks and large, established companies. Almost all bonds that are traded in the US are given a quality rating by companies called rating agencies: AA (very high quality), BB (medium quality) or CC (doubtful quality).

Some bonds have a speculative rating—popularly known as “junk” bonds—because the issuer’s ability to repay is very uncertain.

2. The payback period. Every bond has a maturity date—the period of time until the borrower must repay the lender. This is called the duration¹ of the bond. It can range from overnight to as much as 100 years.

Generally, the longer the duration the more risk the buyer takes on. The reason for this is obvious. Not much usually happens overnight that might affect the value of a bond. But it’s difficult (if not impossible) to foresee what will happen in five, 10 or 30 years.

Another reason longer duration bonds carry more risk has to do with the overall direction of interest rates. (This was the reason bonds lost so much value in 2022. More about that later.)

3. The interest rate. Every bond comes with a promise to pay interest on the amount that’s been borrowed. The interest rate is usually fixed for the duration of the bond and is determined at the time the bond is issued based on:

BALANCING RISKS

When thinking about investment in bonds, buyers need to answer two questions: 1) How much am I willing to risk non-payment to get more interest? And 2) How long am I willing to hold the bond to get more interest?

For example, a bond issued by the US government with a one-year maturity will have almost no credit risk and very little duration risk. You would expect it to pay a very low interest rate.

In contrast, a bond issued by a small and barely profitable company with a 10-year maturity would involve taking both credit risk and duration risk, and therefore demand a much higher interest rate.

The final and perhaps most important thing to understand about bonds is the relationship between changes in overall interest rates and changes in the value of bonds. The events that led to the dramatic losses for bonds in 2022 is a good example of this dynamic:

Let’s say you bought a 3%, 20-year Government bond in 2014, when overall interest rates were historically low. Fast forward to 2021 when the Federal Reserve started to raise interest rates quickly to fight a surprising rise in inflation. All of the sudden companies are issuing bonds at twice the rate you were getting.

Your bond is both paying less and difficult to sell, and its value has fallen sharply: who would want your 3% bond when they could get one at 6%?

The same problem affected the small handful of regional banks that failed in 2023. These banks had invested customer deposits in long duration bonds to capture higher interest rates. When interest rates rose, the value of the banks’ bond portfolios plunged. Panicked customers rushed to withdraw their money causing the banks to become insolvent.

YOUR RPB INVESTMENT OPTIONS

As I noted at the start of this article, RPB participants don’t need to worry about the quality and characteristics of individual bonds when they’re making investment choices for their RPB account. Each of the bond funds in our lineup include a wide range of bonds and are much less sensitive to overall interest rate changes and other economic and market factors than individual bonds.

Using our preset Tier 1 funds or do-it-yourself Tier 2 funds, you can choose the mix of bonds that’s right for your portfolio. Read more about your choices.

About the Author

David Baskin has more than 43 years of experience in the finance, venture capital, and investment fields, and is the founder of Baskin Wealth Management in Toronto.

David is a sought-after financial market commentator, frequently appearing on BNN’s Market Call in Canada and other BNN Bloomberg programs, as well as on CBC Radio.

David is a past president of Holy Blossom Temple in Toronto.

1. Please note that all investments carry some level of risk, including the potential loss of principal, and past performance is not indicative of future results. There is no guarantee that any investment strategy will achieve its objectives or generate profits. Before making any investment decisions, we recommend that you consult with a qualified financial advisor.