Podcast Episode 44: Revenge of the Nerds

In this episode, Colin & Josh respond to listener requests to provide some super technical and detailed content. We’re not sure who made this request. It could be a test to see if the guys really know their stuff (spoiler: they do), or it could have been Josh sending emails from an anonymous address to manufacture an excuse to talk about some of the things he loves the most.

Episode Transcript

BARENAKED MONEY PODCAST: EPISODE 44

Revenge of the Nerds | Part 1

Announcer:
You’re about to get lucky with the Barenaked Money podcast, the show that gives you the naked truth about personal finance with your hosts, Josh Sheluk and Colin White portfolio managers with WLWP Wealth Planners, iA Private Wealth.

Colin White:
So welcome to the next edition of Barenaked Money. Colin is here with the great Josh who is particularly excited about this episode, because as we promise, we listen when people ask us to do things, and I was requested that we should start doing some stuff that’s a bit more technical, a little less fluffy. And when I told Josh, he just couldn’t contain himself. So I think he’s written like 57 episodes now for our podcast to go down the technical wormhole that he loves to live in. Is it 57, Josh? Is that as many as you did or?

Josh Sheluk:
No, only 55. Yeah.

Colin White:
Oh, okay. There you go.

Josh Sheluk:
I just wanted to get us past the a hundred mark and then I figured we had got technical enough by that point.

Colin White:
Yeah. All right. So my job during this episode is going to be to tether Josh, not allowing him to get completely off into another sphere of the academic discussion of any of these topics, but we’re going to begin with bonds. You may think, “Hey, how complicated could that be?” Stay tuned. We’re going to throw it into four wheel low, and we’re going to grind through different aspects of bonds that you maybe didn’t know you cared about or frankly, some of you are tuning out right now and don’t care at all. And that’s fair, because that’s not going to hurt our feelings. But Josh, let me kick it to you first. What is a bond?

Josh Sheluk:
Yeah. Great starting question Colin. I think it’s particularly relevant today because there’s a lot of news out there about bonds and how they’re going to be so punished with higher interest rates, higher inflation, all this stuff. So we’ll come back around and explain how all that stuff actually works mechanically, but to address your first question, what is a bond, a bond is essentially like a loan and you as the bond holder are extending that loan to some other entity that’s borrowing the money from you. And that other entity is promising to pay you a number of fixed interest payments on the lent money. And then at the end of this loan, they’re going to give you back the loaned principle.

Colin White:
And the other interesting thing about bonds that will allude to a whole bunch of other things here is that people buy and sell bonds on a daily basis. Not all of it is completely visible, but depending on which data source you look at, it’s a factor of magnitude more than equities trade every day. So there are billions of dollars in bond transactions going back and forth every day. These bonds are traded for various reasons. Some people are speculating, trying to make money, other people are trying to bolster their balance sheet or there could be a whole bunch of reasons for it. But that’s where a lot of the complexity begins to seep in.

Colin White:
It’s not just a contract that gets written and runs to maturity. Those get bought and sold at everyday. So everyday you get an opinion on what your piece of paper’s worth and everyday that valuation can be different. “How different?” You might ask. “What influences that?” You might ask. I’m glad you’re still here. Josh, there are a couple of broad categories of bonds. Let’s just tease our way down the rabbit hole. Corporate and government, what’s the difference?

Josh Sheluk:
Yeah. So government bond, fairly self-explanatory. With a government bond, you are lending money to a government. And often, that’s going to be a federal government. For example, you can buy a government of Canada bond. So you’re lending money to the government of Canada to do all the wonderful things or not so wonderful things that they do for its citizens. You can buy provincial bonds. So you’re lending to the province of Nova Scotia, the province of Ontario, et cetera, et cetera. In other countries, you’ll have similar federal or state or provincial bonds. And then sometimes you can run down all the way into something like a municipal bond. So anytime you’re lending to a government or a government entity, we’ll call those government bonds. And you can also have some quasi government bonds lending to something like the CMHC, the Canadian Mortgage and Housing Corporation, where it’s a government sponsored entity a little bit at arms length from the government though.

Josh Sheluk:
On the other hand, you have corporate bonds. So if you’re not lending to a government who are you lending to? Well, you’re lending to a company and that’s essentially what a corporate bond is. So instead of lending to the government to do all the wonderful things they’re doing, you’re lending to Royal Bank or Apple or Microsoft or some company that’s going to take your money and going to spend that on building the newest, latest and greatest iPhone or something.

Colin White:
And I think it’s important to note here, and to introduce the concept of rating agencies, because these bonds all to carry different ratings, which is hopefully an objective opinion on the ability of the institution to repay. And theoretically, there is no way for a group inside of a country to have a higher credit rating than the country itself. Is Canada still AAA Josh? I’ve lost track of that.

Josh Sheluk:
Yes. I believe it is.

Colin White:
[crosstalk 00:05:44].

Josh Sheluk:
Yep.

Colin White:
Yeah. So when you start talking about Quebec bonds versus new Brunswick bonds versus Saskatchewan bonds, you can notice those have different credit ratings, which is like your credit scored and the lower the rating than potentially, the more the cost of worrying if you’re an investor, then potentially, the higher the rate of return, but you’re also taking on additional risk. And by the time you get down to the municipal end of the world, you can get into some pretty dodgy municipalities. And I think you’re technically correct, municipalities are governments, but I don’t think that they would satisfy the true definition of what a government bond would engender in somebody’s mind when they think about it. And as in the corporate space, you have a wide range of credit ratings. Whether you’re lending to a major corporation, which is all a balance sheet with a good rating or something less than that.

Colin White:
And I will in do at this moment, something that’s really nefarious in the Canadian bond space, the non-recourse bonds that have been issued by a certain sector in Canada that is trying to protect their tier 1 capital ratio. And in order to protect their tier 1 capital, they need to have equity exposure. So they’ve actually issued bonds into of the space and the bonds have a conversion built into them that sharing a liquidity event, the bond becomes common shares. Therefore, it’s not really a bond.

Colin White:
Are you intrigued? Are you interested? Do you want to keep listening? Yes, you do. And I’m not getting any further with that. So you’re going to have to questions if you want to know what a non-recourse offering into the marketplace is. John, I just made this exciting.

Josh Sheluk:
You just lost a lot of people too. [inaudible 00:07:27].

Colin White:
We won them.

Josh Sheluk:
We did.

Colin White:
We won them.

Josh Sheluk:
We did. So yeah, I think ultimately what you’re looking at when you’re looking at these in talking about these credit rating is the riskiness and the potential that you do not get repaid on your bond. Because just like an individual that can’t afford to pay back their loan from the bank, there could be a company or a government that cannot afford to pay back the loan through the bond that you’ve purchased. And these credit ratings are one way to gauge the risk that a potential company or a bond is not going to pay back that loan, or you are not going to get repaid on the bond that you have.

Colin White:
Yeah. And it is worth noting that there’s an inherent conflict in that relationship that was illuminated in 2008 or so, and this is where the buyer beware comes in. And this is one of the challenges to the doit yourself investor. A lot of the credit agencies are relied on very heavily, perhaps too so as to the quality of the underlying credit. And the doit yourself relies 100% on that as a metric, there are opportunities where those AAA ratings or AA ratings or whatever the rating is, are disingenuous, or don’t tell the whole story. But they are widely used in the marketplace for pricing, they are widely relied upon. They just shouldn’t necessarily be relied upon in a vacuum. They should pay attention to what’s around it.

Josh Sheluk:
Yeah. So generally speaking, when we’re talking about ratings, government going to be higher rated than corporate, and there’s a very wide range of corporate ratings. A company like Apple, who has billions of dollars of cash just sitting in the bank, is going to be very highly rated, whereas Smitty’s Diner down the street and around the corner, maybe not going be as solid of a company that you want to lend your money to, and commensurate with those different levels of risk, higher interest rates or lower interest rates. So lower risk is going to carry a lower interest rate, higher risk is going to carry higher interest rate for you.

Colin White:
So Josh, how do market interest rates affect the price of bonds?

Josh Sheluk:
This comes back to what you were talking about, Colin, what you tease there at the outset that, hey, these bond trade on a regular basis. And the value, the price that they trade at is influenced by the prevailing interest rates on the market. So let me give you an example. Let’s say a year ago, interest rates were quite low and I wanted to take out a loan, for my business, my lemonade stand as we so often refer to. And for this lemonade stand, I’m willing to pay 5% interest on this loan. So you give me a hundred dollars, I’ll give you 5% interest every year on the a hundred dollars that you loan me.

Josh Sheluk:
If today, the prevailing interest rates in the market have gone up substantially, which they have over the last 12 months in real life, then maybe my 5% interest rate doesn’t look so hot anymore. Maybe the 5% that I’m paying you on that bond that you gave me a year ago, maybe it’s not so attractive. Maybe you could go to the government of Canada and get a 5% interest rate. In that case, what happens to the price of the bond that you took out from my lemonade stand a year ago, that price has to go down. It’s not as valuable today as it was a year ago, because you can go out and get a better interest rate on similar or lower risk bonds today than you could a year ago.

Josh Sheluk:
And so you could think of the same thing for any entity, whether it’s a government, a corporation, if interest rates go up in the market and you can go out and find a new bond at a higher interest rate, well, you’re going to pay less for a bond that was paying a lower interest rate before.

Colin White:
Then let’s just get into it. So if that same level of risk in the market was being priced at say 7% at a later date, then what you need to do is discount the price of the bond so that the capital that you’re paying add it to the interest of 5% you’re getting is going to actually equal the 7% in the market. So your a hundred dollars bond is now maybe only trading at $90 or $95, well, per hundred. It doesn’t mean it’s not going to mature for the full hundred dollars, it just means that if you tried to sell it today, you would have to sell it for less.

Colin White:
So there is actual, real deep math that goes into this, discounting that price, so that the effective interest rate of whatever you’re receiving plus what the market is willing to pay adds up to about the same thing. That’s how you see a bond drop in price. It didn’t default, it didn’t lose anything, it just, if I wanted to realize the whole thing today, I’m not going to get my full hundred bucks back.

Josh Sheluk:
Yeah. And the way to look at it is, let’s say the government of Canada took a bond out a year ago at 1%. And today they’re going to take out that same bond at two, why would I pay a hundred dollars for this bond a year ago when I could buy the exact same bond today at 2%. And so that bond from a year ago, the price of that bond has to adjust so that if I’m buying that bond that was issued a year ago, it’s going to give me a 2% rate of return per year.

Colin White:
But you know what we’re teasing Josh, we’re backing into here? We’re talking about the maturity of a bond or the duration risk in a bond. Maybe you could, and this is something I’d get tripped up on for some time, the difference between duration and maturity of a bond and how that goes into affecting the bond price.

Josh Sheluk:
Yeah. This is really interesting because, just because interest rates have gone … Oh, no. Colin is shaking his head for those that can’t see us. It’s not that interesting. Okay. It might be interesting to the few listeners that have stuck around here. It’s very interesting to me.

Colin White:
Good.

Josh Sheluk:
But what I’m trying to say is, interest rates going up or down does not affect every bond in the same way. And let me give you another example. So let’s say I lend you money for a year, let’s just go back to the government of Canada situation. So we lend the government of Canada money for a year at 1% and interest rates out on the market, they go up to 2%. In one year, I’ll get my a hundred dollars back that I lent to the government of Canada, and then I can go out and buy a new bond at 2%.

Josh Sheluk:
So yes, I’ve been disadvantaged for a year because I was getting 1% on my money, but it’s only for 12 months. At the end of that 12 months, I can go out and buy a higher coupon or a higher interest rate bond, not a big deal. Let’s say on the other hand, I lent my money out to the government of Canada for 10 years at 1%. The interest rate in a year is 2%. I still have to wait another nine years for me to get my money back on my bond so I can go back out to the market and buy a new bond at a higher interest rate. So that 10 year bond, that’s a severe disadvantage to me because interest rates have gone up. So that price is going to be more affected than a shorter term bond.

Josh Sheluk:
So all of this is to say, longer term bonds are more affected by changes in interest rates than shorter term bonds are all else equal. And what you’re talking about, Colin is something called maturity and duration. Maturity is a pretty simple concept. It’s the amount of time that it takes for you to receive your principal payment back on that bond. So if I buy a 10 year bond, my money is with that entity for 10 years, and in 10 years, that entity is going to give me my money back. If I buy a five year bond, my money’s with that entity for five years and in five years, I get that money back.

Josh Sheluk:
Duration is a little bit more complex, because what it effectively is, is the average time that it takes for you to get repaid on your money, taking into account all of the cash flows that you get from that bond. Not only when you get repaid the principal, but also all the coupons or interest payments that you receive along the term of that bond.

Josh Sheluk:
So typically bonds pay interest every six months. So you’re not just waiting till the end of the maturity to get everything back. You’re getting a little bit back every six months, and then at the end of it, you’re getting the full principle repayment. Can you still hear me, Colin?

Colin White:
Yep. I can still hear you fine.

Josh Sheluk:
Okay. Because my screens just went black, so I’m going to keep talking, but if at any point you can’t hear me just interject. Okay. I think I’m back now. It’s all back to normal.

Colin White:
Yeah.

Josh Sheluk:
Okay.

Colin White:
So another way of looking at this, Josh, another way of explaining this, there’s a 1% interest movement and I’ve got a five year bond, to be simple, that means I’m disadvantaged 5%, 1% a year for five years. That’s a huge oversimplification. Please don’t correct my math. I know what’s wrong, I’m just trying to make a point. But if I’ve got a one, 1% difference in a 30 year bond, that means I’m disadvantaged for 30 years. So one times 30 is 30%. So that’s a more simpler yet entirely wrong way of calculating the difference in price movements and why it’s different based on either the maturity or the duration of the bond, both of those would be longer ipso facto, right?

Josh Sheluk:
Yeah, exactly. So we’ve been talking a lot about interest rates going up, but the opposites also true, right? So interest rates go up the existing bonds that you hold are disadvantaged, so your bond prices are going down. Interest rates go down the existing bonds that you hold are in a better position, they’re more advantaged, so the price of that bond is going to go up. And the change in the price is going to be directly influenced by that duration calculation that I talked about before.

Colin White:
Yeah. Absolutely. But we’re talking about different interest rates over different time horizons and there’s a term for that. Isn’t there, Josh?

Josh Sheluk:
Yeah. Well, I love the way that you set these up so I can just slam them down, Colin. What Colin is talking about is something called a yield curve. And this is something that’s actually in the media quite a lot right now. So what is a yield curve? Complicated concept, but very simple application. So a yield curve is simply a plot or a picture of the different interest rates over the different durations of time.

Josh Sheluk:
So a one year bond, what’s the interest rate there? You put a little dot on your graph. A two year interest rate, what’s the interest rate there? Well, you put a little dot on your graph. A five year, a 10 year, at cetera, et cetera.

Josh Sheluk:
So generally what you have is an upward sloping yield curve. So shorter term interest rates generally lower than longer term interest rates, because as we’ve talked about, those longer term bonds are going to carry more price risk. There’s more uncertainty over 30 years than there is over the next three months. So you need to be compensated for that uncertainty. Again, we’re grossly over simplifying this, but at a very basic level, this is how interest rates work on bonds.

Colin White:
Well, and it’s important to take this back to how individuals make decisions with their money. Let say I got a client and we’re looking at investment options for them and I can get you an 8%, one year GIC, okay, that eight percent’s a good rate to return. Locking your money up for a year could fit easily within your plan, that’s great. If you want me to lock that same money up for 30 years, I’m going to expect higher normal conditions. I would expect I’d be paid more for that unless the yield curved does something wonky. And we talk about this as a curve like it’s a straight line, but it can wobble. Could it not, Josh?

Josh Sheluk:
Yeah. I said, it’s usually upward sloping. So you’re usually getting a higher interest rate to have a longer term bond, but that’s not always the case. Sometimes different forces in the market and the economy make things change. And occasionally, you’ll have short term interest rates actually being higher than long term interest rates. And that reflects the idea that the market is expecting interest rates to go down in the future when you have that, what’s called an inverted yield curve. So the shorter term rates are higher than longer term rates. You have an inverted yield curve and the market is anticipating interest rates to go down in the future.

Colin White:
Okay. I’d like to make one statement of clarification here and then I’m going to ask you for a comment. The federal reserves set only one interest rate, they set the overnight rate. So the rest of these rates are basically market driven, not withstanding the fact that some federal reserves and some conditions intervene in the markets to try to influence rates, but they are market set rates.

Colin White:
Well, the government of Canada does not set the five year bond interest rate, that’s established in the market. Yes, perhaps with some interference from different federal reserves. But again, it’s not something that’s a policy a that is set. And Josh, we started this conversation a little bit about inverted yield curves. And we have seen a little bit of this happening recently. So let’s put some context around what we’re seeing with regards to inverted yield curves now and what we think that, that or what historically that has told us and what that may telling us now and why we’re not so sure.

Josh Sheluk:
So central banks and the Bank of Canada is what we hear about a lot in Canada set very short term rates for financial institutions. So without getting into all the complexities of how the financial system works, when you have a bank like the Royal Bank or TD or something like that, they need a bank themselves. They need somewhere to put money in what’s called the overnight market. So sometimes they exchange money with one another, and sometimes they exchange money with the Bank of Canada, which is like a government sponsored entity.

Josh Sheluk:
So the Bank of Canada can influence shorter term interest rates on the market by changing what they call the overnight rate. And that’s when we hear about rate hikes or rate cuts, it’s the Bank of Canada that’s really driving these rate hikes or rate cuts. So they do influence things to some extent in the short term, and that does have some influence on the rest of the bonds that are out there in the market, to some extent.

Josh Sheluk:
So historically, an inverted yield curve is painting a negative picture on what the economy is going to look like going forward. Because what it’s telling you is that the expectation is that the Central Bank is either going to increase interest rates quite significantly, or they already have increased interest rates quite significantly, and the longer term expectations for interest rates are more modest than that. So in a way, the pricing of these bonds is telling you that they’ve increased interest rates too much. And when you increase interest rates too much, that stifles the economy. It makes people want to borrow less money, it makes people want to spend less money, when people are spending less money, that means they’re buying less things. When people are buying less things, that impedes corporate profitability, and it has a number of spill over effects.

Josh Sheluk:
So historically, what’s called an inverted yield curve has meant that, “Hey, we should probably be a little bit more cautious on things.” But right now, we’re seeing some aspects of the yield curve invert, but other aspects are not. So two year and 10 year interest rates are inverted, but three month and 10 year interest rates are not. So which one do we trust? And then the other aspect of that is, well, there’s been probably more Central Bank influence over the last 10 to 12 years with these interest rates than there has been at any point in history, so can we actually trust this at all? Has something changed or can we actually rely on this as a true indication of what’s going happen?

Josh Sheluk:
And the third issue with this is, it’s not a timing tool. It doesn’t mean that yield curve, inverts, boom, we have a recession tomorrow and everybody runs for the hills and then yield curve flips back to normal and then you go back about your daily life. It’s not a perfect timing tool. It gives you maybe a little bit of indication what might happen over the next couple of years, but it has no indication of what will happen over the next two days, two weeks or two months.

Colin White:
Yeah. And then this is where you try to turn this topic into a 45 second spot on the Nightly News. And it’s like, “Yield curve has inverted.” Rarely in my career have I ever seen that just be a blanket statement that you could make. To Josh’s point, it’s inverted here, but not here, it’s inverted in this market but not that market. And so it becomes nuanced right out of the gate. And our current environment is so dominated by a global pandemic, geopolitical issues, supply chain interruption, there are so many well, odd signals being thrown into the market right now that this is a, it’s different this time. It would be the cliche way to say it, but there’s a lot of nuance into this conversation.

Colin White:
So there are commentators and commentaries being written about inverted yield curve, run for the hills. And those are being written in a very convincing fashion, but they’re cherry picking their facts and they’re not presenting things in context because there’s no motivation to do that. It’s much easier to dig the hole throw in the snakes and then maybe offer a letter, but just maybe throw in snakes and get you so caught up into watching the snakes that you want to watch more snakes.

Josh Sheluk:
Yeah. Just drowning you with snakes, right now, drowning you with snakes.

Colin White:
That’s, right. It’s like, “Oh my God. I need to see more snakes. I need to see more snakes.”

Josh Sheluk:
Yeah. I’ve probably read 50,000 words on inverted yield curves and what that might mean over the last six months. And we don’t have a definitive position on it. So what does that tell you? It tells you, that is a 45 second sound bite, is probably not going to explain everything that you need to know to make an investment decision.

Colin White:
Yeah. And again, it’s not to mean that we discount it entirely. Yes, we do actually look at it, but there’s many things we look at and I guess the way that I term it, what’s an investible observation versus just an observation? You need to have something that you think that you have enough conviction over and has enough causal power to it that is actually going to cause something in a meaningful way that you believe in before you have something that’s investible. And at the current stage, and this is directed directly at the people who are giving me feedback about wanting content. We’re almost on the cusp of maybe having an opinion as to whether or not the inversion of the yield curve as it currently exists is a leading indicator of anything. We’ll let you know when we become more certain that maybe we’re developing an opinion.

Josh Sheluk:
Yeah. So this is a great segue, Colin. We talked about a lot of the mechanics about how bonds work, how they’re priced, what influences this, but how do we as a group actually evaluate bonds as an investment?

Colin White:
That’s funny, because I’m just going to bounce this right back to you being the member of our team who sits on the committee that runs our bond pool. Because again, this is something, a change we made within our group, it’s a little over a year ago now, isn’t it? Almost a year ago?

Josh Sheluk:
Yep.

Colin White:
Yeah, something like that. And the idea was to create a pool that we could do a few more interesting things with because the traditional market for government bonds and what we call index, like exposure to the bond market, didn’t seem all that appealing. So we decided to try to branch out as much as we could. The danger in this is, and where people get this wrong, and I have watched professionals do this. I’ve got a global, balanced, mutual fund that’s low risks, therefore, that’s my bond.

Colin White:
When interest rate expectations get to a certain really low point, people start to reach and they start to say, “This is just like a bond. This performs like a bond.” And they get themselves into a bit of a problem. We haven’t been willing to go as far as some other organizations are with regards to managing the current situation, but there are different things and I’m not going to comment anymore, Josh because you’re the one that sits in on the meetings. So why don’t you tell the good folks what we look at when we’re putting together our bond pool.

Josh Sheluk:
Yeah. So when you’re evaluating bonds, obviously I think we’ve made it clear, first and foremost, you need to have some expectations for interest rates. And what you said was really interesting there, Colin again, maybe not, it’s not interesting depending on who you ask, I found it interesting, but what has happened over a last really, 30 or 40 years is, interest rates have come way, way down. And that means that the rate of return expectation on your bonds has come way, way down as well. And that’s a bit of a challenge for people that are relying on a good, fairly safe source of income and growth for their portfolio. And what you’ve seen a lot with the different investors that are out there, professional or otherwise, is that they’ve continuously ramped up the risk that they’re taking to compensate for lower interest rates.

Josh Sheluk:
And that comes with a bag of hammers or a pit full of snakes or whatever you want to call it, they’re ramping up risk. So if things go poorly, that can be very detrimental to portfolios. What you’re seeing today is some much similar, I think, where you have a lot of market commentators saying that you need to abandon all of your bonds because interest rates are going up. And that is a risky statement to make. Because yes, we as a group, even here internally, we do think interest rates are going to continue to go higher, but I wouldn’t bet my life on it. I wouldn’t bet my house or my farm on it, or even my car on it. I have enough uncertainty about what the future looks like to make sure that I maintain a degree of safety in the client portfolios that need it and maintain a certain level of bond exposure, because hey, if we’re wrong and interest rates go the other way, what’s going to perform best in your portfolio?

Announcer:
We know this week’s episode was pretty technical. I’m whispering. So I don’t wake up those folks who didn’t make it all the way through, but if you’re still here and you’re still interested, there will be a part two, stay tuned.

Announcer:
This information has been prepared by White LeBlanc Wealth Planners, who is a portfolio manager for iA Private Wealth. Opinions expressed in this podcast are those of the portfolio manager only and do not necessarily reflect those of iA Private Wealth, Inc. iA Private Wealth, Inc, is a member of the Canadian Investor Protection Fund and the Investment Industry Regulatory Organization of Canada. iA Private Wealth is a trademark and business name under which iA Private Wealth, Inc operates.

Colin White:
We’ve noticed something, it seems there’re a lot of people who would rather try to figure out their lives with an online calculator than air your finances to a human. Stop doing that. You need to talk to someone who can help direct you, tell you where to start with what you got to make the biggest impact on your future. You can’t figure that out at doIhaveenoughcash.com, but you can figure it out by chatting with us. Call us. It’ll be okay. You’ll see.

Announcer:
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Announcer:
This podcast has been prepared for information purposes only. The tax information provided in this podcast is general in nature and each client should consult with their own tax advisor, accountant and lawyer before pursuing any strategy described herein as each client’s individual circumstances are unique.

Announcer:
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