An introduction to bonds
Self-directed investors have access to a wide range of investment products in their online brokerage accounts. While some investors are focused on stock-oriented securities in their online brokerage accounts, bonds and other fixed income products can help diversify your portfolio, provide investment income and help you manage risk.
In this article, we’ll look at:
- What bonds are
- How bonds work
- How to make money on bonds
- Basic bond terminology
- Types of bonds
- Bond risks
- How to incorporate bonds into your portfolio
What is a bond?
Simply put, a bond is a loan that you, the investor, make to a corporation or government (also called the “issuer”). You (the lender) earn interest in return for providing corporations or governments (the borrowers) the cash they need to operate.
When a company or government needs to raise money to invest in growth and development, or to acquire another company, it can sell (or “issue”) bonds. Governments also issue bonds, which are the primary way they raise money to fund capital improvements such as highways or airports. Money from bond issues also keeps everyday operations running when other revenues (like taxes and other fees) aren't available to cover current costs.
A bond pays interest over a fixed period of time (or “term”) and is set at the time of its issue. When the bond matures at the end of the term, the investment amount (or “principal”), is repaid to you. Typically, the rate at which interest is paid and the amount of each payment is fixed when the bond is issued. That’s why bonds are known as “fixed-income securities” and one reason that a bond may seem less risky than an investment (such as a stock) where the return can change dramatically in the short term.
How do bonds work?
A bond is a loan that pays interest over a fixed period of time (or “term”). When the bond matures at the end of the term, the investment amount (or “principal”), is repaid to you.
The term of any bond is fixed or set at the time of its issue. The term of a bond can range from short term (usually a year or less), to intermediate term (two to ten years), to long term (30 years or more). Generally speaking, the longer the term, the higher that bond’s interest rate. This is to make up for the additional risk of tying up your money for a longer period.
The value of a bond is determined by the interest it pays and by what's happening in the economy.
A bond's interest rate doesn’t change even though other interest rates will. If the bond pays more interest than is available elsewhere, you, as an investor, will probably be willing to pay more to own it. If the bond pays less, the reverse is true.
Interest rates and bond prices fluctuate like the two sides of a seesaw. When interest rates drop, the value of existing bonds usually goes up. When interest rates climb, the value of existing bonds usually falls. Several factors – including yield and return – affect whether or not a bond turns out to be a good investment.
When bonds are issued, they are sold at “par”, or face value, usually in units of $1,000. The company or government that is offering the bond (also known as the “issuer”) absorbs whatever costs are incurred to issue the bond. After their issue, bonds trade in the secondary market, which means that they are bought and sold through brokerages, similar to the way stocks are traded. The issuing company or government receives no money from these secondary trades.
How to make money on bonds
There are two main ways to make money with bonds.
1. Interest payments
When you buy a bond, it usually will pay you regular interest payments while you hold the bond and, upon the bond’s maturity, you’ll receive the face value (your principal investment) paid back to you.
For example, if you purchased a five-year bond in the amount of $10,000 at an interest rate of 3% and held it until maturity, you’d receive interest payments of $300 ($10,000 x 3%) for each of the five years. For the entire term of the bond, your return would be $1,500 ($300 x 5 years).
2. Selling the bond for more than you paid for them
Bonds that are issued when interest rates are high become more valuable when interest rates fall. For example, let’s say you own a bond with an 8% interest rate, but the current rate on bonds is 5%. As a result, investors may want to buy your bond from you to get the higher interest rate. So, you can make money by selling your bond before it matures because you’ll receive more than you paid for it. However, the reverse is also true. If interest rates rise after you purchase a bond, the price (or value) of the bond declines. So, if you decide to sell it prior to maturity, you could lose money.
The issuer of the bond is the company or government that is raising money. Investors can buy bonds issued by various sources, including the Canadian government, foreign governments, Canadian and U.S. companies, cities and provinces, as well as government agencies such as Crown Corporations and local airport authorities.
The term of a bond can range from short term (usually a year or less), to intermediate term (two to ten years), to long term (30 years or more). The life, or term, of any bond is fixed at the time of issue.
Generally speaking, the longer the term, the higher the interest rate. This is to make up for the additional risk of tying up your money for a longer period.
A bond’s yield is the rate of return you earn. If you bought a 10-year $1,000 bond paying 6% and held it until it matures, you would earn $60 a year (or a total of $600 over the ten years) – for an annual yield of 6%, which is the same as the interest rate.
Before you buy a bond, you will want to be reasonably sure that you’ll receive your interest payments on time and your principal back at maturity. Bond rating services (such as Standard & Poor’s, Moody’s and DBRS Morningstar) are private companies that scrutinize the financial condition of a bond issuer (its “creditworthiness”) and provide ratings on bonds based on their opinion of that issuer or bond’s level of risk. Bond rating agencies consider factors such as any debt held by the issuer, how fast the company's revenues and profits are growing, the state of the economy, and how well other companies in the same business (or comparable governments) are performing.
The higher the bond rating (AAA or AA+, depending on the rating agency) the lower the risk of you not receiving your interest payments. The lower the bond rating (C or D, depending on the rating agency), the higher the risk.
Types of bonds
There are a wide variety of bonds, and a lot of jargon to describe them, but it’s important for you to understand the features of all the fixed income products available so you can choose the one(s) that best suits your needs. Below are some of the more common categories of bonds.
- Corporate bonds are bonds issued by companies. Corporate bonds typically are “debentures”, which means that they’re backed by the company’s reputation and creditworthiness rather than specific assets. Companies can also issue “asset-backed bonds” are backed by specific assets, such as property or equipment. Corporate bonds are fully taxable and generally offer a higher yield than government bonds, which are usually considered a safer investment.
- Federal bonds are issued by the Government of Canada and are a major source of government funding. They can be intermediate term (2 to 10 years) and long term (10 to 30 years), and are backed by the “full faith and credit” of the government, which has the power to tax its citizens to pay its debts. These are bonds of the highest credit quality, but generally have lower interest rates compared to corporate bonds.
- Federal Treasury bills (or “T-bills”) are short-term (under one year) federal government bonds, which represent the largest component of the money market. Investors use T-bills for part of their cash reserve or as an interim holding place. The Bank of Canada allows reinvestment for up to two years without a new application. T-bills are the safest of all shorter-term bonds, but provide a lower return.
- Municipal bonds are bonds issued by cities and provinces or other governmental organizations to pay for projects. Municipal bonds are subject to lower interest rates than comparably rated corporate bonds, but generally have higher rates than federal treasury bonds. They are not as safe as federal government bonds.
- Investment-grade bonds are high-quality bonds, generally considered safe investments because you're highly likely to receive regular interest payments plus the face, or par, value of the bond when it matures.
- High-yield bonds are riskier than investment-grade bonds. Investors who are willing to take risks for higher yields tend to buy corporate or municipal bonds with lower ratings – or no ratings at all – commonly known as “junk bonds” or “high-yield debt.”
There are also risks that should be considered in bond trading. Many bonds are backed by the creditworthiness of the issuing company or government, and if it defaults (if it cannot pay back the loan), you can lose all or a portion of your investment.
If interest rates rise, you could lose money by selling an older bond, which is paying a lower rate of interest. That is because potential buyers will typically pay less for the bond than you paid to buy it.
The other risk bondholders face is rising inflation. Since the dollar amount earned on a bond investment doesn't change, the value of that money can be eroded by inflation. For example, if you held a 30-year bond paying $5,000 annual interest, that money would buy less at the end of the term than it did at the beginning.
How to incorporate bonds into your portfolio
Usually, more conservative investors use bonds to provide a steady income. They buy a bond when it is issued and hold it, expecting to receive regular, fixed-interest payments until the bond matures. Then they receive the principal back to reinvest.
More aggressive investors tend to trade bonds as they might with stocks, hoping to make money by selling a bond for more than they paid for it. Bonds that are issued when interest rates are high become increasingly valuable when interest rates fall. An increase in the price of a bond, or its capital appreciation, often produces more current profits for bond sellers, than they would by holding the bond to maturity.
Laddering your portfolio
You can employ a technique known as "laddering", where you choose investments with different maturity dates and split your total investment among the different bonds. As each bond comes due, the principal becomes available for you to reinvest. Laddering is a way to keep your investments fluid and at the same time protect yourself against having to invest all your money at once if interest rates are low.
How to buy bonds
If you don’t want to purchase individual bonds directly, there are other ways to have bond exposure within your portfolio. You could include a bond-focused mutual fund or ETF, which may give you exposure to the broader bond market, or could invest specifically in corporate or government bonds, or be based on bonds with different time horizons or from different geographic regions.
If you’re ready to buy and sell bonds, simply log in to your Qtrade Direct Investing account. From your dashboard, head to Trade > Fixed Income, click on the Fixed Income tab and click on Fixed income module. It will take you to the Fixed Income Order page. Click on Buy or Sell and it will pull up a page where you can select the type of bond you’re looking for, searchable by bond category, yield, issuer, coupon rate and/or maturity.