What are bonds?

Bonds can be a decent investment option with steady income. But depending on the bonds, your return can be much lower than other investment options.

What are bonds?

Bonds are an asset class much like stocks, commodities and real estate. But unlike these 3, bonds represent loans made by investors to borrowers. These borrowers are known as bond issuers and are often either government or corporate entities.

Aside from paying back the principal, the bond issuer also pays interest — which can be fixed or variable. This is known as the coupon. Because the bondholder earns interest, bonds are also known as fixed-income securities.

2 types of bonds

Bonds are designed to provide the bond issuer with funds for investments or expenditure. Depending on who issues the bond, there are 2 major types: Corporate and government (including federal, provincial and municipal).

1. Corporate bonds

Companies may resort to traditional loans or bonds to get funds for investments or to cover day-to-day operations. Because bonds often come with lower interest rates and more favorable terms than traditional loans, companies may prefer to choose the bonds route.

But since companies may go bankrupt or fail to pay off their debt, corporate bonds can have a higher risk than Canadian government bonds.

• Corporate bonds are usually part of a public offering, where a company issues a prospectus informing investors about the offering and allowing them to make a direct investment in the business.
• Strip bonds (also known as zero-coupon bonds) separate or “strip” apart the interest and principal of a bond and resell each component as a separate investment. On maturity, investors receive a single payment representing the current value of either the principal or the interest.
• Maple bonds are issued by foreign financial institutions and companies that want to raise money in Canada. Non-accredited investors can only buy maple bonds that are government-guaranteed or issued by certain agencies that aren’t based in any country are are therefore above national regulation.

Tax implications: Interest earned from corporate bonds are subject to both federal and provincial income tax.

2. Government bonds

As the name suggests, government bonds are issued by the federal, provincial or municipal governments and are often referred to as “Treasuries,” T-Bills or sovereign debt. Backed by the government, these bonds are considered one of the safest types of investments.

Depending on the length of the bond’s maturity, government bonds have different names. For example:

• Government of Canada Real Returns Bonds are backed by the Canadian federal government, and the principal is adjusted for inflation.
• Provincial bonds are backed by the provincial authority to levy and collect taxes. Interest is paid 2X a year. On maturity, bonds are sold at the current market value.
• Municipal bonds (also called “munis”) are issued by cities, counties, school districts and sometimes redevelopment agencies often to fund local projects such as schools, sewers and highways.

Tax implications: Interest earned from government bonds are subject to federal and provincial taxes.

How bonds work

When a company or government entity needs money either for investments or day-to-day obligations, it can issue bonds. The bond issuer sets the terms, i.e. the bond’s face value, maturity date and interest rate.

The maturity date is the day when the bond issuer has to pay the principal back to the bondholder. The interest rate is the amount, say 3% annually, paid to the bondholder.

The face value is what the bond issuer will pay for each bond on the maturity date. It’s also the value on which the interest rate is calculated.
Here’s how that would work:

1. Company X issues a bond with a face value of $1,000, a 2% interest rate and 10 years maturity. Because bonds are negotiable, meaning bond ownership can be transferred to the secondary market, the bond can be resold and bought again at a different price by other investors.
2. If an investor bought the bond on the market at a discount, say $900, the bond issuer would pay back the face value of $1,000 when the bond reaches maturity, thus the investor earns an additional profit on top of the 2% annual interest rate.
3. Suppose the same investor bought bonds for $9,000 in the second year after the interest was already paid and held it until the maturity date. The investor would earn $2,716 in interest and in face value difference. That’s a total of around 30% earned in 8 years.

For comparison, the same $9,000 investment in the S&P 500 index with an average annual return of 10% would earn $10,192, or a 114% return.

Bond market price and interest rates can change

Bond interest rates are often determined by creditworthiness and the date of maturity. If the bond issuer has a poor credit rating and the risk of default is high, the interest rate will be high as well. The opposite also applies. Low-risk bonds, such as treasuries, pay low-interest rates.

The bond’s issuer credit quality also affects the market price on the secondary market, meaning quality bonds may cost more than the bond’s face value.

Key terms to know

Bond ratings

Bonds are assessed by bond rating agencies that take into account the issuer’s financial strength and its ability to pay back the principal and interest on time.

DBRS Morningstar (Dominion Bond Rating Service) is a credit rating service based in Toronto that assesses the credit-worthiness of businesses to determine the risk level of investments. Other popular rating agencies include Moody’s, Standard and Poor’s and Fitch Ratings.

Each of these agencies has its own grades, but in general, bonds with an AAA rating are considered investment grade with low risk. On the other hand, bonds rated CCC are considered junk with a higher risk of default.

Where to find ratings

Finding bond ratings is simple no matter which agency you go with. For example, if you choose Fitch here’s how to find the ratings:

1. Visit fitchratings.com.
2. Select the search tab.
3. Enter the company name or the country you wish to find.
4. Make sure to use the company full name — eg. Ford Motor Company.
5. Submit.

Advantages of bonds

Typically offering lower returns than stocks, bonds may not be the first choice for growth investors. But other investors may find the advantages of bonds appealing.

• Steady income. Bond interest rates provide investors with steady income each year.
• Preserving capital. On the maturity date, the bond issuer pays back the entire principal to the bondholder. This can serve as a way to preserve capital.
• Less volatile than stocks. Choosing the right bonds can help you avoid volatility.

Drawbacks of bonds

Despite its advantages, there are some risks to consider.

• Bond issuers may default. The bond issuer may fail to pay the interest rates and the principal to bondholders.
• Inflation. Rising inflation may eat up the bond’s interest rates value.
• Low liquidity. Depending on the bonds, you may find it hard to sell them on the secondary markets.
• Call risk. Some bonds are callable, meaning the bond issuer can buy them back before they reach maturity.

How to buy bonds

There are 2 main ways to buy bonds: Via a brokerage platform or as an exchange traded fund (ETF). You can buy government bonds directly from the government, but the process is more complex. It’s easier to buy government bonds directly from your broker.

1. Buy bonds from a broker

Accessing the bond market via an online brokerage is one of the simplest and fastest ways to buy bonds. Here’s how:

1. Find a broker that offers bonds — for example, Interactive Brokers.
2. Open an account and fund it.
3. Request access to trade bonds, if required.
4. Look for the bonds you wish to purchase on the broker’s platform.
5. Create a Buy order, which can go under the Ask name.

2. Buy bonds as ETFs

ETFs provide a simpler way to invest in bonds. That’s because not every broker lets you buy bonds, but almost every broker allows you to buy ETFs. To buy a bond ETF, you need to:

1. Have an account with an online broker.
2. Find the ticker symbol of the bond ETF you want to buy.
3. Enter the number of shares you want to buy.
4. Review your order and submit.

Bottom line

As an asset class, bonds are worth considering for investors looking for low-risk, fixed-income options. But this only works for investment-grade bonds. Junk bonds may be good for those who want to make higher returns, but the risk of default is also high.

Frequently asked questions

• What are bonds in simple words?

  Bonds are fixed-income investments that represent loans from investors to government or corporate borrowers.

• How do bonds work?

  When a company or government entity needs money either for investments or day-to-day obligations they issue bonds. Each bond has a face value, maturity date and interest rate.

  The maturity date is the day when the bond issuer has to pay the principal back to the bondholder. The interest rate is the amount paid to the bondholder, and the face value is what the borrower will pay on the maturity date.

• How do bonds make money?

  Investors earn money from bonds from the interest rate paid by the borrower.

• Is the government still issuing Canada Savings Bonds?

  No. Due to the high cost of administration, the Government of Canada stopped issuing Canada Savings Bonds (CSB) and Canada Premium Bonds (CPB) in 2017. Unredeemed CSBs or CPBs will still be honoured. Visit the Canada Savings Bond website to learn more.

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