I know this is supposed to be a dividend / equities blog, but I can't not mention fixed income every now and again.
Fixed income is a massive market relative to equities. For the most part, the companies we all own shares in likely have numerous bond issues outstanding in the market, so it's important to understand where equity lies in the pecking order of things.
Here's today's predicament (for the small guy or gal). I'm going to put a Canadian spin on this (apologies to our US cousins), simply because the fixed income offerings I've managed to find at my brokerage are basically all Canadian issuers. I want to search the offerings but keep the duration low enough as rates really have nowhere to go but up (the longer the duration, the more sensitivity a bond price has to changes in interest rates).
Unless you sacrifice credit quality, you're paying over 100% of par as long as the coupon is higher than current prime (2.7% in Canada), which is usually the case with most issuers these days. There's nothing wrong with paying 100% of par if that's your thing, but if you plan to hold to maturity, anything trading at a significant premium to par will ultimately mature at par, giving rise to a capital loss at maturity. Case in point, if you bought a bond at 130 maturing in 5 years, it won't mature at 130...it will mature at 100, giving rise to a loss of $300 per $1,000 of par value held. The trade off is that the investor banks interest until maturity.
In Canada, you can use 1/2 x the $300 capital loss to apply against net capital gains as long as the bond is held in a non-taxable account, so buying bonds at the moment could be viewed as a tax shelter if an investor expects to realize significant capital gains. The problem here is that, Canadian investors would probably prefer to hold bonds inside non-taxable accounts (RRSP's, TFSA's) due to the tax treatment of interest outside of non-taxable accounts. In this case, the investor loses the ability to use the capital loss. Why bother in the first place?
All of the above in mind, I searched my brokerage's inventory of strip bonds (these are bonds which are separated into a principal component sold as a zero coupon and a series of interest strips) in a search for yield. Here's what I found today (October 20, 2015):
Strips, 0-5 years:
Inherent in any zero coupon is interest rate sensitivity and credit/issuer risk. If I wanted a 5yr yield to maturity of 2.42%, the best strip on offer is Bell Canada's 10/15/2020 strip. For anyone interested, if you want to buy this stuff at TD, you have to pay their offer. The spread is quoted in terms of yield. Their bond desk will buy strips at 2.79556, or 87.112, and will sell strips at 2.42273, or 88.720. Doesn't seem like much, but figure that these strips are sold in minimum lots of $5K, and they have 10,730 lots on offer, they earn a spread of $80 per $5,000 lot x 10,730 lots, and the desk does this all day every day. You wonder why banks make gravy. PS, you can't get inside TD's spread. It's fixed. Retail pays the offer. Period.
Knowing this, here's what TD offers in terms of GIC's. Same duration, no risk:
I can almost get the same 5 year yield (minus 22 bps) with no risk by buying a 5 year GIC paying 2.21.
This leads me to my next two questions. 1) Why bother committing to a duration of 5 years, and 2) Is corporate credit risk over and above GIC's really only worth 20 bps between now and 2020?