My “Wordle” Favourite is a Big Part of Today’s Investment Climate

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Like a lot of people, I’m crazy about the daily online puzzle game Wordle. It involves guessing a five-letter word using a process of letter elimination. It requires you to start with any word.  Everyone has their favourites. Some of mine are “early”, “point” and “yield”.

I remember the first time I saw the word yield. I was a child and I was watching my mother bake cookies. At the end of the recipe, it said “yields two dozen”. My mother explained that was how many cookies the recipe would produce.

Over the years, I’ve found that most people don’t understand the concept of yield in investing. Like with the cookies, it helps explain what a security will produce as a percentage of the investment. That’s where people get tripped up.

Let’s say that for $100, you could buy a share of a company that pays $3 in dividends annually. Your yield would be 3%. If next week, the shares were trading at $105, the person who bought them would also receive $3 annually in dividends, but his or her yield would be only 2.86%. They had to invest more money than you to receive the same dollar amount of dividends, so their “yield” is lower in percentage terms (3/105=2.86). If the stock had fallen in value and they had purchased at $95, their yield would have been higher – 3.16%.

As Prices Rise, Yields Fall.  As Prices Drop, Yields Rise.

It’s been a tough year for investments so far. Both stocks and bonds have fallen in value. Many investors have not experienced a significant drop in bond values before.  Bonds are dropping because interest rates are rising. Sounds weird, doesn’t it? Your instincts may have had you believe that rising rates would be good for bonds. It’s good for a newly issued bond or a GIC at the current rate. But it generally causes the market value of existing bonds to fall. Here’s why….

Let’s say that a couple of years ago you bought a $10,000 government bond that would mature in ten years and which paid interest of 1.5% annually. At the time, that may have been the going rate. But with interest rates going up, another investor would not want to purchase that bond from you for the face value of $10,000. They’d be stuck with $150 in annual interest for another 8 years. If the going rate is closer to 3% for an investment of that length of time, they’d have to adjust how much they pay you to achieve a yield of 3% for themselves. The interest payments are $150 per year; 1.5% of $10,000. For them to achieve a 3% yield, they’d have to buy it from you for closer to $8,900. They would receive $150 in interest payments each year and they’d receive the $10,000 face value of the bond in eight years when it matures – $1,100 more than they paid you. That would allow them to achieve a return of about 3% – something we call “yield to maturity”.

Bonds are usually part of a diversified portfolio. When you think of a typical “balanced” investment, the balance that is described is between stocks and bonds; usually around 60% stocks and 40% bonds. Bonds provide stability. Generally, their values fluctuate less than stocks. And, their values often move opposite to stocks. When investors get nervous about the stock market, they usually turn to bonds.

Like stocks, there are many categories of bonds – Federal, Provincial, Corporate, Global, High Yield, Inflation Linked. And there are an even greater number of vehicles to invest in them such as different mutual funds and exchange-traded funds. Many factors and characteristics such as the issuer, the credit quality, the interest rate or “coupon”, the maturity date, liquidity, currency – all contribute to how they will perform.

Unlike GICs, there is a market for bonds. Investors can buy and sell them and their prices fluctuate daily based on all of these factors. Your GICs don’t fluctuate in value because no one can buy them from you and therefore, no market value or price is set for them. You are locked in until they mature and the financial institution that issued them gives you your money back.

For readers who are not clients of mine, I’d be happy to review your investments to help you understand how you are positioned. A properly designed portfolio takes advantage of the opportunities offered in all categories of stocks and bonds to attempt to achieve returns and to mitigate risk.  It needs to reflect your goals, your capacity for risk and your overall situation.

You shouldn’t abandon bonds.  It’s important to remember that over 90% of your return and volatility are determined by how you are positioned among the main categories of investments such as stocks as bonds.  Fittingly, the term we use for those categories could end up being what you’re looking for in Wordle one day.  Asset Class.

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