E17: Bonds... Just Bonds with Richard-Usher Jones

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I must also advise you that unlike

other episodes, this will be a single topic focused podcast Bonds Just Bonds. Today on the Unlimited Podcast, a special episode back to basics on bonds with bonds 101. What is a bond?

How do they work?

How are bond coupon or interest rates determined?

And why do they change?

Bonds versus equities and much, much more. Let's. Welcome everybody to a special episode of the Unlimited podcast by Gensler Wealth. A few weeks ago, we had the pleasure of sitting down with Richard Usher Jones, portfolio manager at Canso Investment Council, a $35 billion plus investment manager focused on fixed income, also known as bonds, also called credit in some cases. And a portion of that discussion, a large portion of that discussion, was a education or what we call bonds 101. The financial world is not always well known to our clients and listeners. They're experts in their industries, their fields, their professions, but finance might not always be their expertise. So we like to do a lot of education with clients on different investment and financial concepts and what we're doing

and how the portfolios work.

And so in that spirit, we wanted to record a large portion of our discussion with Richard as a Bonds 101 primer for folks that read about, hear about, are always, you know, seeing the media and newspapers and others talk about bonds and interest rates, but maybe don't quite have all the 101 background on it. And so I hope you enjoy this special episode.

We're going to cover bonds.

How do they work? Coupons, interest rates, bond ratings, the bond market versus the equity markets, what happens to bond prices when interest rates change, et cetera, et cetera. I hope you enjoy hope you come away from this a little bit more educated on the world of the fascinating, I should say, world of bonds.

Here we go. Everyone talks about the equity markets. The papers are equity markets. The news is equity markets. What's the size of the bond market relative to the size of equity markets? Just to give listeners some context, give

or take, you know, I'd say

the

actively traded bond market, those that are liquid and actively traded, it's about twice the size of the equity market, but I'd say it's actually also Much bigger than that because there's a whole other category of debt that wouldn't be included in that and that's leverage loans, bank loans, private debt. So you know, safe to say, while the, the bond market, a lot of people, it doesn't get the attention and sort of the fanfare that the equity market does, but it absolutely dwarfs the size of the stock market.

Right.

And that's my understanding as well. And so I think just to give listeners context, this is a, a major, major piece of the capital markets and much, much bigger than equities would be. Although equities tend to get all, all the glory. I guess.

So.

Okay, so let's go back to, all the way back to basics. So first of all, what is a bond? And just in general, how does a bond work? These are really basic, I know, but you know, you're going to be the expert to explain this to us better than, better than I can, I guess.

Well, it sounds like a basic question, but you kind of don't know what level they answer that. And I think right when I think of a bond, it's really a contract between two parties, let's say yourself and myself. Right. If I have excess cash and you're in need of cash. Well, basically we create a contract where I can lend you that money for a period of time and I'll probably put some caveats and some protections on that. And in our world you call those covenants, but also we're going to agree for the length of time that you're going to borrow that money from me and also how much you're going to pay me for the use of that money for that period of time. And typical bond, say it's a 10 year contract that you and I have. I'm going to lend you say $10,000 for a period of 10 years and we'd agree on a rate of interest. And let's say that rate of interest is 5%. That means you're going to pay me 5% each year for the right to use that capital of $10,000. And you typically get, you get paid that rate of interest twice a year. So it's a semiannual rate of interest or what gets called a coupon payment.

Okay. And so is this where you hear this term clipping coupons? What does that mean?

It's funny, you know, that the term coupon is one that I've got a son, actually two sons that are doing bcom degrees and I've tried to explain to them what a bond is and how A bond works. And one of the terms we use.

You were practicing before the podcast. It sounds like this is perfect.

Well, practicing. But I hope my two sons don't hear this. I don't think I've been successful in trying to explain to them how it works. But if you, I, I had to imagine in learning this years ago of what a bond is. A bond was a piece of paper that was a contract, and attached to that main principle, the, the bond were a whole bunch of different coupons. And if it was a 10 year bond, they were 20 coupons.

Every coupon you're talking literally physically attached to a piece of paper that you would take off.

Literally.

Yeah, yeah.

Well, actually you wouldn't rip it because these were pretty valuable. So you take a really sharp pair of scissors.

Yeah.

And you know, you call it clipping the coupons. You would cut that coupon off.

Yeah.

And you could go into a bank or a participating institution and they would pay you, pay you the value of that coupon and they take that coupon and submit that back to the, back to the issuer.

Right.

And so when you, when you hear that term of you buy your bond and you just sit back and you clip the coupons, that's exactly what they were talking about years ago. You actually had bonds with the principal value and coupons were attached to it. And that's, that's where that term came from.

Amazing. The old school, the old school approach. And, and, and the terms continue. So you were talking about you and I entering a contract, but, you know, assuming we're not doing that, I'm not good credit. You don't, you don't want to borrow from me, that's for sure. Who, who issues bonds generally?

I borrow from you, I just might not lend you money.

Exactly, exactly. So who are the issuers of bonds that you would mostly. And investors would mostly be interacting with the issuer being the lender on the other side.

So I'd say some of the biggest issuers on the planet are countries like the government of Canada, US Government issuing US Treasuries, and all of the provinces issue debt as well. And you know, these are federal and provincial issuers. But then one thing that we specialize in, can specialize in at Canso is in evaluating bonds that are issued by different businesses and corporations. So when you're, when you're buying a government of Canada bond, you're basically, you know, you're, it's the ability of the federal government to tax us as, as citizens. Right. And the taxes that we pay and, and that's actually what services the interest payments on those bonds and somewhere on the provincial side.

And that's why people say government bonds are pretty close to risk free because they can always just tax, tax, tax if they get into trouble and, and pay off bonds

pretty much. I, I kind of, I, I, I don't outright answer saying, yeah, for sure that's guaranteed because as you know, nothing in life is guaranteed.

But also, yeah, I'm talking, I'm, I'm thinking sort of Canadian government bonds or U S bonds, not necessarily other countries that, you know, may have some troubles.

Yeah, I'd say, I mean if there's a default in the government, a North American government bond, we've got some pretty concerning issues.

We're in a bunker somewhere if that's, yeah. And, and of course, corporations would also be doing this because they, they can issue equity potentially if they're public or otherwise, but bonds would be another way to finance their business or their growth, I guess.

Yeah, no, that's, that's the difference. When you're, when you're evaluating a corporate bond, you're really spending a lot of time understanding that, that business, that underlying business and how it operates, how it generates cash flow because it's that cash flow in the business that's going to be there to, to service the debt and to pay you your interest and allow that business to refinance when it matures.

Right, okay. So using, just following on the, you know, the governments are issuing bonds and corporations are issuing bonds. As you said right at the beginning, obviously a key component of a bond is the interest rate or the coupon payment, which actually may be different things, if I'm not mistaken. You can, you can explain why do we see why, why is there different interest rates or coupons for, for different issuers, Governments, corporates, federal government versus provincial government versus BCE or Rogers or Air Canada. What determines the interest rate?

Yes, I'd say there's a couple different ways to look at it. You know, first off, the environment, whereas, you know, if you look at today interest rates are, are measurably higher than they were a year ago. Right. So you're issuing within that particular interest rate environment. Right. And then the different rates of interest on different bonds are really an indication of the health of that business. Or you can look at it on the negative side. What are the chances that they may not be able to pay you and the more risk that exists in the ability for those interest payments to be made? Typically the higher the rate of interest you need to get paid. So a more fragile business would typically have a higher coupon payment or be paying you a higher rate of interest and essentially paying you for the risk that they may not be able to continue to pay you.

Right. Okay. And so, and, and so I, I, I mentioned a moment ago that actually let me, let me ask a skill testing question first. Not to you, but to the listeners and then bring that back to this coupon and interest rate. So skill testing question for listeners. What happens to bond? And of course I'm not actually going to be able to hear if anyone answers, but you know, just for fun, what happens to bond prices if interest rates rise? So right now the government is raising rates at a pretty rapid clip. What happens to existing bond prices if interest rates rise? Very, very important concept that essentially every investor who's investing in bonds and frankly every investor period should understand. And, and if you don't, then you should definitely call us against their wealth, by the way. But what happens to, to bond prices of interest rates rise. Bond prices go down and vice and vice versa. And maybe Richard can explain why that is and also therefore explain. Cause I think I made a comment before, you know, coupon rates and sort of the interest rate I guess are not necessarily the same. Maybe I'm not using the right language, but cause bond prices change. So can you explain, Richard, why do bond prices fall if interest rates rise and vice versa and then how, how does the coupon and whatever make up for that change?

Yeah, so I guess the way I think about it, I've got to think about actual examples. And we've seen some significant moves in interest rates in the last year, as I mentioned. So let's take a simple example and say two years ago you could have bought a Government of Canada bond and it, it would have been priced at say $100. The par value and interest rates were very low.

And par value means. Sorry, what the face value of the bond.

Correct, face value. And most bonds are issued at face value of $1,000. Right. And you talk about them in increments of $100. So you go, yeah, face value, par value, a hundred dollars.

And that's what you lend and that's what you have to get back whenever it matures.

Correct.

Okay.

And then you're paid those coupon payments or those interest payments twice a year.

Right.

For the use of that money when you lend it. So let's say, and, and you know, I probably should have looked to see exactly where rates were. But as an, I know there are a Number of government of Canada bonds in circulation that only pay a rate of interest of 0.25%. Call it 25 basis points. Right. So say you had a, a year ago, you bought a two year bond that was paying a rate of interest of 0.25%. So that's 1/4 of 1%. Interest rates were very low a year ago. Well, you roll forward to today, that was a two year bond when you bought it a year ago. Yeah. It's got one year left of maturity.

Yeah.

A one year government of Canada bond today is yielding about 4.3%. So no one's going to pay you a hundred dollars. That bond that's only paying 0.25.

Right.

So basically. But you know that that bond matures at a hundred dollars in a year.

Yeah.

So you basically discount that bond and the cash flows on it, that you've got two cash flows remaining, or actually three cash flows. You've got two interest payments of 12 and a half cents and then you've got that principal return of $100. So you know, sort of simplifying this, someone would pay you basically, you know, discounting that bond, probably $96 for that bond. And why do I say $96? Because you're going to get the two interest payments, 12 and a half cents plus that $4 discount is that rate of interest you're not going to make if you bought a Government of Canada bond today.

Right.

And you know, whenever I think when we're evaluating a bond and say a corporate bond, all we're really doing is applying discount cash flow models saying what are the cash flows we're going to get paid and we're going to attach a single price to that today. And when you talk about whether a particular company or bond is more risky, essentially what you're doing is you're evaluating the likelihood you're going to get paid. And the less likely, the more you better get paid.

Right.

And that's why, I guess, I mean, maybe during, I don't want to jump ahead of ourselves here, but maybe during COVID that those first month or so when the world looked very scary, I guess I'm assuming bond prices for corporates or others would be coming down to reflect some increased risk. Is that what, what you saw then?

Well, at the beginning of COVID it was a significant shock to the market. And the shock with every, every business operator was looking around saying, how is this going to impact my business? And for some businesses it was incredibly detrimental, like the leisure and travel business that all travel Basically stopped and ended then. And you know, the question was, how long is this going to last and how much cash do we have in order to keep the business alive and surviving? So, so the, you know, I have to say the shock that we saw and the interruption, the business interruption for so many different industries was so significant that caused everyone to take a real step back and, and try and figure out what all these new investments were worth.

Right. So we talked a little bit about interest rates and risk of different countries and companies, etc. You know, you hear the terms, you know, AAA rated or, or bonds or junk bonds, which doesn't sound so good, but maybe, maybe they are. Fine. Can you just explain sort of how somebody, and maybe you can explain also who is evaluating these sort of bonds and assigning ratings and what does that mean for interest, for coupon rates or interest rates?

Sure. So there are a number of different credit rating agencies and some people might be familiar with the name of Standard and poor's or DVRs, which stands for Dominion Bond Rating Services or Fitch Rating Services. And essentially when a company or an entity issues a bond, oftentimes they will pay a rating agency to rate their debt. And the higher the rated the debt, the lower the probability of default or the higher the probability of the chances you're going to get all your money back and there's no risk to it. So essentially every entity that's issuing debt wants to have the highest rating possible because that, that permits them to finance with the lowest rates of interest possible. Right. And the way the ratings will work is the Highest rating is AAA or AAA high flat to AAA minus the double A the double A flat to double A low and then single A, and then the notch down from single A is triple B and there's triple B high and B flat and triple B low. So there's lots of notches on the way down and it goes all the way down to single B. And then after single B is getting a D on your, your, your high school assignment, D is default. That means that the issuer has defaulted, they're no longer paying their interest, and it means that you're likely not getting the full value back of what you lent that entity in that business. And just going to quickly go back to that triple B and triple B low rating. Because when you go from triple B low could double be high. That, that's a significant differentiator because anything rated triple B and above is considered to be investment grade. Everything rated double B high and below that is considered to Be, actually there's three terms they're used. Junk bonds, high yield or below investment grade. And anything double B or below

is,

is rated junk, high yield or below investment grade. And you know, what are those? Why do they have different names? I don't know. Actually. I think if you don't like lower rated debt, you call it junk. If you like it, you call it high yield. And if you're kind of ambivalent, ambivalent, you call it below investment grade.

And so is there a problem investing though in junk bonds or high yield bonds? Because it seems like something lots of folks are doing. I know Canso invests in, in this space as well. So maybe just describe how you, or how bond investors could get comfortable with bonds that some might call junk bonds.

Sure. So we, we do we have the ability to invest in high yield or junk bonds. Um, and you know, the important thing there should really need to make sure you're doing your work because you're really evaluating that business and the company, their ability to service that debt. The other thing which I alluded to in the beginning is let's say go back to an example where I'm lending you $10,000 if I'm concerned that you may not be able to pay me back if you're a lower rated credit. Sorry, Brian.

Yeah, I'm junk. I'm a junk. Yeah.

I'm maybe going to put some caveats or some covenants in there and I'm going to say, well, your car is probably worth 10 or $12,000. So I'm going to secure that loan of $10,000 against the value of your car. And by the way, you're not allowed to sell your car to anybody else in the period that this loan is outstanding. So if, if you cannot continue to pay the loan, well, I can take possession of your car, I can sell it, I can recover that money and that $10,000. And if I get more than 10,000, you would get the extra money back.

Right.

So it's, it's really evaluating not just the business or the entity's ability to pay their interest and to refinance it, but also what protections that you need to have in order to get comfortable in lending that money.

And I assume as the ratings go lower and lower, which I guess is into that junk bond or worse territory, the interest rate would, would commensurately be going up and up and up. So if I'm, if I, if, if Brian Gensler's a junk bond, I'm paying you a way, I imagine a Way higher interest rate than, you know, Justin Trudeau is paying you for a Government of Canada bonds with. No comment on Justin Trudeau just,

no, that, that, that's exactly it. You know, the higher the perceived risk of the money that you're, you know, or the entity you're lending to, you should be, you should be paid more for that risk. Right. So, and so in terms of that rate of interest.

So, you know, sometimes when the market gets a little challenging or, or otherwise, you know, I, I, I've seen some investors get really excited. Oh, this is amazing. Someone's issuing a bond that's paying 14%. Like, this is awesome. Let, let's, you know, I, I think the key is they gotta understand that there's a reason you're able to get 14% on a particular bond. And that reason must mean in almost all cases that there's something much more risky about it than, you know, say, other bonds that are paying far less interest.

Correct, Correct.

Okay, so I, I still want to talk about bonds. Sorry.

You know, to give you an example, I always, I'm kind of, I have to think about examples. In our portfolios, we've owned bonds that have been issued by Apple. Right?

Right.

So Apple, I've got, well, you're on my Apple iPhone right beside my Apple iPad. They're, they're a company that is very highly rated, rated double a, very low probability of default, tons of cash on their balance sheet, and frankly, we would say very little risk in being a lender to Apple. So because of that, you're not actually paying that much rate of interest.

Right.

Whereas in the portfolio in the last couple of years, we've lent to a number of airlines. And while air travel's returning and Air Canada is doing quite well financially, there was a period in time where the business was under a lot of pressure and we were comfortable at the time lending to some of the airlines, American Airlines, Air Canada, and more recently Latam, which is an airline based in Latin America. But because of that, we had to get proper protections with security, meaning recourse with assets behind that debt instrument. And also a much more attractive rate of interest than say you would get from an Apple. Because you think, I mean, maybe those are drastic extremes, but pretty good illustrating example.

Yeah, I actually want to come back to some of those airline bonds that you bought when we get into post the bonds 101 section. But let me just repeat what you said and maybe ask a question. So Apple, which is the largest company in, you know, if not the largest, posted the largest company in the world is described as you did tons of cash earning billions and billions and billions of net income each quarter, and you said their bonds would be rated double A. And double A is not the highest rating bond. AAA would be. Is there any company whose bonds would be rated higher than Apple then? Or like, what's Apple missing that its bonds couldn't be rated aaa? Or is that just reserved for really stable governments?

Pretty much just governments. I'm thinking of instances we've bought some bonds issued by Canadian banks where unsecured debt of the Canadian banks can be rated triple B. But there are some categories of debt rated aa. But also they've issued covered bonds that are rated aaa. And a covered bond is not only backed by the promise of the bank to pay, but also if it's covered, there's an additional pool of assets that are also backing that investment. So there can be some, some covered bonds that have significant coverage in backing that can be issued by corporations that are rated triple A, but it is quite rare.

Okay, so I have a few more questions about bonds in a second, but just switching back to everyone's favorite, which are equities. I say that jokingly, but, you know, maybe a very simple. And everyone knows the answer to this question, but as you think about stocks and bonds, which one is safer if, you know, all else being equal and. And why?

Well, you know, I definitely have to say bonds are certainly the safer asset because if you look at the, the capital structure of, of say, a business, right, if that business were to, to go into bankruptcy, the bond holders need to get paid back before any money gets paid to the equity holders.

Right?

But what you forego with that is, you know, you've got unlimited upside when you're buying the stock or the equity of a business that, assuming it does very well and continues to grow, you participate in that. Whereas if you buy a bond or you own a bond from a company that's paying you 5%, you're not going to do better than that. 5%, right?

Yeah, it's a. Exactly. It's a risk reward trade off. You're getting no more than what the bond is contractually obligated to pay. But you're also first in line if something goes wrong. I think, I think that's really the core of what I was trying to get at for people to understand. Bonds get, you know, again, very simplistically, bonds get paid first and then, and once and only once all the bondholders are paid back, then the company could start paying some of the Equity holders. Okay, so I think, I think that's a Pretty good bonds 101. Only one question I'm going to ask that may be getting into the Bonds 201 question, but we're starting to hear this term. Well, sorry, the term's been around for forever, but starting to hear more. The yield curve. There's something called the yield curve. Can you just, and this is important for interest rates, both, you know, current rates, future rates, et cetera. But can you explain to listeners what's the yield curve and what does it look like?

Sure. I mean, that's a bit of a loaded question because the look of it can change.

Well, exactly what's it typically look like? Let's say typically as a start.

So if you were to build a yield curve, you typically do it with, with say government Canada bonds, if you're investing in Canada and the yield or the rate of interest that is available and be paid on bonds of 1 year, 2 year, 5 year, 10 year, 20 year and 30 year. And you would plot those, and you would plot, you know, across time being on the, on the lower axis and you would plot those rates of interest. Right. And what a normal yield curve looks like is you would take the longer term that you're lending money, the higher the rate of interest. Right. So in a normal environment, if you're making 3% in a one year bond, the 30 year bond might be 5% and it's a gentle upward sloping curve and that's where you get the term yield curve. And so that's how you plot the yield curve.

And the concept being why for listeners, why would the interest rate traditionally or typically be higher on a 30 year bond than a 2 year bond? Like why, why, why is the curve sloping upward? You know what I mean?

Yeah, I mean that's, that's debatable if it's the same credit risk like the government of Canada, but you're locking your money up for longer so you should be paid more. And there's a lot more uncertainty in that period between now and 30 years that you're subject to. And so you're, you're paid more for that.

Yeah, those assumed risks, it's, it's I guess the concept of time value of money along with uncertainty, et cetera. So generally it, the longer you give someone your money to hold on to, the more they have to compensate you for it relative to, if you're just lending someone money for a year, you're gonna, you know, there's much more knowns in the next 12 months than there are in the next 10 years, give or take. Okay, so if that's what a typical yield curve looks like, what does the yield curve look like today? And today being, you know, middle of December, government has increased both in Canada and the U.S. and elsewhere in the world, increased interest rates dramatically over the past 10 months or less, frankly. What does the yield curve look like today?

The yield curve does not look like the normal yield curve I described. It's, it's quite inverted. And so if you were to actually plot those, my, you know, I would, plotting that I would start with say a three month treasury bill which is yielding about 4.2%, and then a one year which is about almost 4.4%. But then if you stretch all the way out to a 30 year government of Canada bond, it's yielding about 2.8.

So almost like it's upside down.

Correct. There's a distinct inversion to it where basically the highest point is at one year and it just gradually declines from there out to 30 years.

Why is that?

You know, if I, if, if I knew that definitively I'd be. Yeah, so, so one of the arguments is that an inverted yield curve is a potential sign that we have a recession around the corner.

Right.

And you know, I think the concern is we've seen a significant lift in interest rates, the overnight rate by the bank of Canada and by the Fed and that's all to address higher inflation and hopefully bring that inflation in check and really to get in front of demand and growth in the economy. And you know, there is, there's a number of investors, maybe the yield curve is telling us that there could be a potential recession around the corner. And, and I'm being kind of cautious in my choice of words because frankly, nobody knows definitively.

Right. I, I had a good friend of mine and famous economist David Rosenberg on as a guest of this podcast a good number of months ago, spoke with him recently, saw some of his presentations recently. And to your point, Richard, at least from Rosenberg's perspective, based on the stats and the charts that he's produced, generally, every time, generally. And this is not a promise or a forecast by Gensler wealth or Richard or otherwise, but generally when the yield curve inverts, there is a recession that follows for a period of time after. And I guess the yield curve's inverted because I folks expect that the rates, that will be the longer term rate, eventually rates are going to get lowered again to counteract the recession potentially and maybe the yield curve returns to normal. But again we'll see what happens in the world, but definitely want to be cautious now.

So thanks again to Richard Usher Jones, Portfolio Manager of Canso Investment Council for helping us explain bonds 101 in this special edition of the Unlimited Podcast, hopefully you walk away with a little bit more knowledge on bonds and how they work. And of course at Gensler wealth we are always available to answer any questions and explain financial concepts in more detail, so feel free to reach out. Thanks for listening.

This has been part of Brian's conversation with Richard Usher Jones of Canso Investment Council. This podcast is not to be taken as investment advice and is not an endorsement of Canso Investment Counsel. For the full episode and more go to ginslerwealth.com podcast this has been a Ginsler Wealth Audio production. The Unlimited Podcast is hosted and produced by Brian Ginsler and is edited and mixed by myself, David McMillan. Don't forget to rate the podcast and follow us on social medianslerwealth. Thanks for listening and see you next time.