What is a bond?
When you buy shares(stocks) in a company, you own part of the company. Your compensation can be in dividends paid to you and/or an increase in the price of the share over time.
When you buy a bond from a company, you are lending the company money. Your compensation is interest income, usually paid annually or semi-annually. The original amount you lent the company can either be repaid gradually with the interest income or in one lump sum at the end of the bond term.
(Bonds can also be traded in certain circumstances and you can make money from selling them, but that’s an advanced topic for another day.)
Why would I want to buy a bond?
Bonds are less risky than stocks.
The regular interest that bonds generate is called fixed income.
Because bonds are less risky and have fixed income, bond returns are lower than stocks.
But bond income can help offset stock losses over time. Fixed income from bonds can be used to keep the stocks at their optimum level so that when the stock market is on the rise, you reap the most benefit.
The importance of asset allocation
Based on the length of time to invest – 30 years – and the results of a risk questionnaire I fill out, it is determined that the ideal asset mix for me is 20% fixed income and 80% equities:
$20,000 in bonds – fixed income – 4% annual interest
$80,000 in stocks – unpredictable annual returns, but assume average 5% over 30 years
$100,000 total invested (20% bonds, 80% stocks)
One year later…
$20,000 in bonds increased by 4% to $20,800
$80,000 in stocks…bad year in the stock market…decreased by 1% to $79,200
$100,000 total invested (20.8% bonds, 79.2% stocks)
So, not the best investing year for me, but the bond interest made up for my small loss in stocks, so at least I didn’t lose money.
So I leave everything alone, right?
Keeping the balance
Our percentages are off. We need to get back to the 80/20 split. Right now I have too many bonds, based on the risk assessment I took.
Maintaining the 80/20 split is key to overall growth.
So I use the $800 I made in bond interest and I use it to buy $800 in stocks.
The bonds become a tool to offset the riskiness of the stock market.
We do this every year. Maintain our asset allocation and therefore maintain our level of risk.
But why is it so important that I rebalance?
Consider a situation where you don’t have any fixed income to use to get your stocks back to 80%. Maybe you have $20,000 in cash, which stays the same after one year.
So at the end of year 1, your stocks are at $79,200 and your cash is $20,000.
You now have $99,200. What’s the next step?
Do you invest another $800 of your money to get the stocks back up to $80,000?
What if this is just the beginning of a 5-year market slump and your $80,000 goes down $800 or so each year? Do you wait until the 5 years is up and then invest on the way up?
How do you know the right time to buy?!
Now you’re guessing. Guessing is also known as gambling.
Asset allocation removes all of these impossible decisions and guessing.
You decided on 80/20, and you’re going to stick to 80/20.
You don’t have to try to predict the stock market – you stick to the plan.
You should have invested your $20,000 in bonds instead of leaving it as cash. If you did you would have the $800 you need to get your stocks back up to where they should be.
You set it, rebalance annually, and then put away the crystal ball.
Ok, I get why bonds are important – so what are these solar bonds all about?
There are two major categories of bonds: government bonds and corporate bonds
Government bonds are issued and backed by the federal or provincial government and are probably the least risky bonds. But they also have really low returns. See my post on Ontario Savings Bonds as an example.
Corporate bonds are issued and backed by individual companies. Companies can go bankrupt or face the inability to pay their bondholders. The risk is low, but it’s there, and therefore the returns are a bit higher than government bonds.
Solar bonds fit somewhere between a government bond and a corporate bond.
The major incentive to buy solar bonds is that they offer a 5-6% return which is very enticing to investors.
There are 2 options for Solarshare solar bonds in Ontario:
Option 1: 15-year bond, $10,000 investment(minimum), 6% simple interest
For this 15 year option there is a catch: they start paying you back the principal along with the interest every 6 months for 15 years.
This means that you only get interest on whatever they haven’t paid you. Makes sense, if you think about it – if they return your money, you can go invest it somewhere else.
But it also means you don’t really get 6% a year for 15 years, or $600/year, as it might appear at first glance.
Because they are paying you back over the life of the bond, the total interest you end up getting over 15 years is $5,305, which is around $350/year. It works the same way as a mortgage, but in reverse – as time goes on, you get less interest and more principal repaid.
So you might want to take the money you get every 6 months and invest that in something else to make sure you are maximizing your overall return.
Option 2: 5-year bond, $1,000 investment(minimum), 5% simple interest
This one is much simpler.
You get $25 every 6 months for 5 years and then at the end you get your $1,000 back or you can invest more. $250 on every $1,000.
And the risk?
Solar bonds are technically low risk for the next 20 years since they have 20-year contracts with the government of Ontario.
So it’s like they are backed by the government, but only for a limited time.
That doesn’t mean that other factors like general business risk and poor management won’t affect their ability to pay their debts.
Remember there is risk in everything. The risk is low in this case, but it’s never zero.
Profiting from the sun
So the returns are decent, and the risk is low, plus you are investing in renewable energy.
So why isn’t everyone buying these?
Here are a few reasons:
- Solar bonds are new – people don’t like new – new is scary
- Simple interest is not the best – people like when interest builds on interest. Also the declining balance of the 15-year bond doesn’t help that case. You get less than simple interest, but you do get your money back earlier. But all that sounds complicated, doesn’t it?
- They qualify as RRSP/TFSA-type investments, but because they are new, you may have trouble convincing your advisor of this. Some advisors may be wary to sign off.
- Buying individual bonds isn’t as popular as buying Bond ETFs where you buy little bits of a bunch of companies and spread out your risk
- There is paperwork to fill out and a $40 co-op fee. You also have to have an Ontario address to qualify.
- People generally don’t know about them. I just heard about these bonds last week.
But now you know about them and you can decide if they are something you want to buy. You can find out more about Solarshare solar bonds here.