Investing in bonds or bond funds can often involve a lot of investment jargon. In this primer, we look to make bond investing simpler by breaking down the key aspects of this important asset class.
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What are bonds?
Bonds are essentially IOUs. Unlike stocks, which represent ownership in a company, bonds represent a loan that must be repaid with interest. Governments or corporations issue bonds when they want to raise funds for large projects or operations. Generally, when you invest in bonds, you are lending money to the issuer in exchange for periodic interest payments.
Generally, bonds have a set maturity date —the date when the issuer must fully repay the loan. Bonds typically have terms ranging from one to 30 years.
Bonds are considere d ‘fixed income’ investments because they provide investors with regular, pre-determined income through interest payments, offering a steady cash flow.
Benefits of bonds
- Lower volatility: Bond prices tend to be less volatile than stocks, providing more price stability.
- Predictable income: Most bonds provide a consistent and predictable income stream from interest payment.
- Principal repayment: If you hold a bond to maturity, you’ll usually receive your initial investment back.
Risks of bonds
- Default risk: If the bond issuer defaults, you may not get your principal back.
- Interest rate sensitivity: Bond prices are sensitive to interest rate changes, which can affect their value.
- Inflation risk: High inflation may erode the value of the interest income from the bond.
The type of bond you purchase will depend on your financial goals, risk tolerance, and investment horizon. Bonds are typically categorized into two main types: government bonds and corporate bonds.
Government bonds
These bonds can be issued by different levels of government. They are used to finance large projects like infrastructure. Bonds issued by stable, developed countries (e.g., the United States, Canada) are considered lower risk because the likelihood of default is minimal. In contrast, bonds issued by emerging market countries tend to carry higher risk but offer higher yields to compensate investors for the increased risk.
Corporate bonds
These bonds are issued by companies seeking to raise money. Corporate bonds can be further categorized into investment-grade bonds and high-yield bonds. Investment-grade bonds are issued by financially stable companies and offer relatively low risk. High-yield bonds are riskier because they may have a higher risk of default, but they offer higher interest rates.
The risk ratings of the bonds are provided by third-party bond rating agencies such as Moody’s Standard & Poor’s and Fitch. These agencies asses the creditworthiness of the issuers and their bonds.
To learn more about the different types of bonds read:Understanding the bond market
How do bonds work?
Typically bonds are initially sold at their ‘par value,’ which is typically $1,000 per bond. When you buy a bond at par and hold it to maturity, you’ll get regular interest payments. You’ll also get your initial investment back, regardless of market conditions (unless the issuer defaults).
While the amount of interest the bond pays does not change, the price of the bond can vary. This is to keep up with changes in current bond yields. A yield is the total income earned from a bond’s interest payments. It is stated as a percentage of the bond’s price (as in a 5% yield). Simply put, bonds that offer higher yields are worth more. When bond yields rise, the value of existing bonds declines and vice versa.
Bond value (i.e. price ) and yield move in opposite directions
Example: Say a bond was issued last year with a 2% yield, but rates have since climbed You can now buy one with a 5% yield. Naturally, investors will want to buy the new bond that offers more income. If someone wants to sell a 2% bond before it matures, they must lower the price to make it more attractive to a buyer.
In brief, prices of existing bonds will change to keep up with current bond yields. To get a fuller picture of how this works read: What are bond yields?
Several factors can impact bond prices, including:
- Interest rates: When central banks lower interest rates, bond prices tend to rise. Conversely, rising interest rates can lead to falling bond prices.
- Economic conditions: During periods of economic uncertainty, investors often move from stocks to bonds, pushing bond prices up.
- Credit ratings: A bond issuer’s credit rating affects the bond’s price. If an issuer’s rating is downgraded, the bond’s price usually drops. The creditworthiness of an issuer and their bonds can be assessed by bond rating agencies and third-party financial analysts.
Understanding these factors can help you appreciate the risks and opportunities in the bond market. Learn more: How to find opportunities in the bond market
Bonds are an important part of a diversified portfolio. They offer a few important benefits:
- Diversification: Bonds tend to perform better than stocks during periods of stock market volatility, reducing overall portfolio risk. In part it’s because they react differently to various economic events, such as interest rate movements and inflation.
- Income generation: Most bonds pay interest, which provides a steady income stream. This can help reduce your portfolio's volatility by generating income even when stock prices decline. Again, this is in part because they react differently to various economic events, such as interest rate movements and inflation.
- Lower investment risk than stocks: Unlike stocks, repayment of the principal is often guaranteed.
Learn more about the role of bonds in a diversified portfolio: How to choose the right mix of investments for you
Bonds are taxed in two ways:
- Capital gains tax: If you sell a bond for more than you paid for it, you’ll be taxed on the capital gains you earn.
- Income tax: Interest payments from bonds are taxed as income at your marginal tax rate. That’s the tax rate that applies when you file your yearly income tax return.
To reduce the taxes due, you may want to consider holding bonds in a tax-sheltered account like a Registered Retirement Savings Plan (RRSP) or a Tax-Free Savings Account (TFSA).
View: Mutual funds and taxes
You can purchase bonds in several ways:
- Direct purchase: You can buy individual bonds through a financial institution. This may be more complex as you will need to manage the maturities of the bond and research the credit quality. Unlike stocks, bonds are not traded on a stock exchange. Instead, sales transactions are done through a broker.
- Bond funds: A simple way to invest in bonds is by purchasing bond mutual funds or exchange-traded funds (ETFs). These provide exposure to a diversified portfolio of bonds. Within the portfolio, there are a variety of bonds with different interest payments and maturity dates. Also, many bond funds are professionally managed by investment teams to achieve specific objectives. Buying or selling bond funds can be done through a self-directed account or with the help of a financial advisor.
Bonds are an essential component of a well-diversified portfolio. They offer stability, income, and the potential to reduce risk. However, the bond market can be complex. A financial advisor can help you better understand how bonds fit into your overall investment strategy.