In this article, we dive into the world of bonds and how they can fit into your investment strategy. We’ll cover the following topics:
- different bond types
- risk and return characteristics of each bond type
- how to invest in bonds
Money market securities
Key features:
- Safest segment of the fixed income market. Typically, lower returns than bonds
- Short term maturity less than a year (a few days or months)
Money market securities (i.e. money market funds) are not considered bonds, but they fall under the broader category of fixed income-investments. They include treasury bills (T-bills), commercial papers, and bankers’ acceptances. In general, they are considered to be the safest segment of the fixed income market.
T-Bills are short-term debt securities issued or guaranteed by federal, provincial or other governments. The stated interest rates for T-Bills are fixed when issued, but values fluctuate based on changes to the central bank rate. A T-Bill’s return is calculated based on the difference between the price paid and the par value (also known as the denomination or face value). T-Bills mature at par (typically 90 or 180 days) and do not pay fixed interest payments like most bonds.
Commercial paper and bankers’ acceptances are issued by corporations. A commercial paper is a negotiable promissory note with a term of a few days to a year and is not generally secured by company assets. A bankers’ acceptance is a short-term promissory note bearing the unconditional guarantee (acceptance) of a major chartered bank. Bankers’ acceptances offer superior yields to T-Bills, with higher quality and liquidity than most commercial paper issues.
Considering the characteristics of money market securities, they are better suited for conservative investors looking for a short-term way to park cash, while bonds cater to investors seeking safety and income over the longer team.
Government bonds
Key features:
- Issued by national, provincial, or municipal governments to finance public projects or operations.
- Considered low risk as they are backed by government.
Issued with terms to maturity between 2 and 30 years, government bonds are considered very low-risk fixed income investments as they are backed by governments. The value of government bonds fluctuates based on supply and demand in the market – a government will increase the supply of bonds to raise money, which will be used to stimulate the economy. Demand for government bonds tends to increase during periods of low confidence in equity markets as investors seek safety. Demand also tends to increase in periods of weak economic activity when the threat of inflation is minimized.
Corporate bonds
Key features:
- Moderate to high risk depending on the company’s creditworthiness.
- Higher yields than government bonds to compensate for the risk.
Investment grade corporate bonds are issued by corporations with good credit ratings. The bond rating agency Standard & Poor assigns credit ratings of AAA, AA, A, or BBB to investment grade bonds. These bonds offer a slightly higher stream of income than government bonds because they are not guaranteed by the government.
The difference in rates (interest-rate spread) between corporate and government bonds generally rises and falls as a result of investor confidence, investors’ willingness to take risks, the outlook for the economy and growth in corporate profits. (Interest-rate spread – or simply spread – is used to describe the difference in rates between different types of bonds.) With investment-grade corporate bonds, investors assume the risk that the issuing company might not be able to make its interest and principal payments. The risk of investment-grade corporate bonds, however, tends to be very low.
High-yield corporate bonds
Key features:
- Often lower credit ratings than investment-grade bonds
- Can offer higher yield than investment grade bonds to compensate for the increased risk
High-yield corporate bonds are sold by corporations that do not have the same high credit rating as investment-grade issuers. Standard & Poor’s assigns credit ratings of BB or lower to high-yield bonds. Historically, high-yield bonds have provided investors with a higher yield than investment-grade corporate or government bonds. This higher yield helps to compensate investors for the risk of the issuing company not making its interest and principal payments. Due to their higher risk of default, the interest-rate spread between high-yield bonds and government bonds is wider than the spread between investment-grade corporate bonds and government bonds.
Emerging market bonds
Key features:
- Issued by governments or companies in developing countries
- Higher yields to compensate for greater political and economic risk
- Currency risk may also be a factor
Emerging market bonds are issued by governments or companies in developing countries. Emerging market bonds typically pay higher yields than investment-grade bonds in both Canada and the U.S. This extra yield pays investors for the added risk of investing in countries with shorter records of sound economic policies and less established institutional and governmental frameworks. In recent years, many emerging market countries have adopted conservative banking and regulatory regimes – similar to those in Canada – which have reduced the risk and increased the credit quality of their bonds.
Convertible bonds
Key features:
- Hybrid of bonds and stocks
- Offer fixed interest with potential for equity gains
A convertible bond is a fixed income security that gives the holder the option to exchange for a fixed number of shares at any time. As a hybrid security, convertibles have debt and equity features that provide investors with the downside protection of bonds and upside potential of equities, while exhibiting lower interest rate sensitivity than traditional fixed income securities.
Like any bond, convertibles are issued with a stated coupon, maturity date and redemption value. But they also come with a conversion option that allows you to exchange them for a certain number of shares of the issuer’s stock at a stated price.
The main appeal of holding convertible bonds in a fund or portfolio is that they offer equity-like performance with bond-like protection. Convertibles can be seen as an alternative to direct equity exposure.
Learn more: What are convertible bonds
Risk and potential return levels
Fixed income investments are not all created equal, and therefore it is important to hold a diversified mix of fixed income investments in your portfolio. Each segment, however, reacts differently to changes in interest rates, the economic outlook and other market factors.
This chart generally illustrates the various risk and potential return levels for T-Bills and a variety of bond segments.
How to invest in bonds
Unlike stocks, bonds are not bought and sold on a regulated exchange, such as the Toronto Stock Exchange (TSX) or New York Stock Exchange (NYSE). They are considered ‘over-the-counter’ investments, which means they are bought and sold through a broker or some discount online brokerages.
You can also invest in bonds through bond funds (mutual funds and exchange traded funds). Bond funds can hold a diversified basket of bonds, are cost efficient and can be purchased or sold with ease. Investors can choose a fund that helps them meet their objectives, including capital preservation or steady income generation.
Conclusion
Bonds can vary widely in terms of risk level, income and return potential. They may respond differently to changes in interest rates. Diversifying your fixed income portfolio by investing in multiple types of bonds has the potential to offer a number of important benefits.
Read: Building a diversified bond portfolio