What are bonds? A full guide for Canadians
Bonds are a long-term investment for passive income. But if you’re seeking liquidity—or big returns—you might want to look elsewhere.
Bonds are a type of investment that can provide steady income and help protect your money. They’re generally safer than stocks, but returns can be lower, depending on the type of bond you choose. Understanding how bonds work, their risks and how to invest in them can help you make smarter investment decisions and balance your portfolio.
Key takeaways
- Bonds provide predictable interest payments and are generally less volatile than stocks, making them a good choice for preserving capital.
- Government bonds are low-risk, investment-grade corporate bonds offer moderate returns and high-yield bonds come with higher risk but potentially higher interest.
- Bond interest is taxable as income in Canada, while buying bonds through registered accounts or funds can provide tax advantages.
What are bonds?
A bond is a type of fixed-income investment that acts like an IOU, typically issued by government or corporate entities. By purchasing a bond, you lend money to the issuer in exchange for regular interest payments — usually at a fixed rate. When the bond matures, the issuer repays its face value, giving you back the principal you originally invested.
Because bonds provide predictable interest payments and are generally less volatile than stocks, they’re often used to preserve capital, generate steady income and balance out risk in an investment portfolio. Some bonds even offer guaranteed returns, making them a reliable choice for risk-averse investors.
How bonds work
Here’s an example of how a bond works:
- Company X issues a bond with a face value of $1,000, a 2% interest rate and a 10-year maturity. Bonds are negotiable, meaning ownership can be transferred to the secondary market, allowing investors to buy and sell them at different prices.
- 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.
- Suppose the same investor bought bonds for $9,000 in the second year after the interest was already paid and held them 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.
Types of bonds
Bonds are designed to provide the bond issuer with funds for investments or expenditures. 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 bond 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.
- Investment-grade corporate bonds: Issued by financially stable, well-rated companies. Since the risk of default is relatively low, they usually offer moderate interest rates.
- High-yield bonds: These bonds come from companies with lower credit ratings. Since these issuers pose a higher risk of default, they must offer higher interest rates to attract investors.
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.
Government bonds come in different forms depending on the issuing authority and the bond’s features, such as inflation protection. Common types include:
- Government of Canada Real Returns Bonds: Issued by the Canadian federal government, these bonds are adjusted for inflation, helping you protect your investment’s purchasing power. Interest is paid semi-annually, and the principal increases with inflation.
- Provincial bonds: Issued by provincial governments, these bonds are backed by the province’s ability to levy and collect taxes. Interest is paid semi-annually, and the principal is returned at maturity at the current market value.
- Municipal bonds (munis): Issued by cities, counties, school districts and sometimes redevelopment agencies, often to fund local projects such as schools, sewers and highways. Interest payments are usually semi-annual, and the principal is returned at maturity
How does bond pricing work?
A bond’s price is influenced by its interest rate, the issuer’s creditworthiness and market conditions. Bonds issued by highly reliable entities, like the federal government, are considered low-risk and typically offer lower interest rates. Conversely, bonds from issuers with weaker credit ratings carry higher interest rates to compensate investors for the added risk.
On the secondary market, a bond’s price can fluctuate based on changes in interest rates and the issuer’s perceived risk. High-quality bonds may trade above their face value, while riskier bonds may sell at a discount.
How do bond rates impact bond value?
Bond interest rates and bond values move in opposite directions. When market interest rates rise, newly issued bonds offer higher yields, making existing bonds with lower rates less attractive, so their market value falls. When market rates drop, existing bonds with higher interest payments become more desirable, driving their prices up.
2 ways to buy bonds: Individual bonds vs bond funds
Investors can access the bond market in two different ways: Either by buying individual bonds or investing in bond mutual funds or exchange traded funds (ETFs). Each approach has its own trade-offs in terms of features like liquidity, income predictability and diversification. Here’s an overview of the key differences between the two options to help you decide which one suits your investment goals.
| Feature | Individual bonds | Bond ETFs/mutual funds |
|---|---|---|
| Control | High — choose specific bonds and maturities | Low — fund manager selects bonds |
| Diversification | Limited — must buy multiple bonds yourself | High — funds can hold thousands of bonds |
| Liquidity | Can be low for some bonds | ETFs: high — trade anytime during market hours Mutual funds: moderate — redeemable daily but only at the end-of-day price |
| Risk | Depends on the issuer and maturity | Spread across many bonds, but interest risk remains |
| Fees | Usually none beyond trading costs | Management fees apply |
| Income predictability | High if held to maturity; fixed interest payments | Income can fluctuate as interest is typically reinvested |
| Ease of use | More research required | Easier for beginners as it’s professionally managed |
| Pros |
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| Cons |
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| Best for | Experienced investors seeking control, specific maturities or predictable income | Beginners, hands-off investors or those seeking a diversified, lower-maintenance investment |
How to buy individual bonds
You can buy government bonds directly from the government, but the process is more complex, so most people go through a 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, and it gives you control over exactly which bonds you own. Here’s how to buy bonds from a broker:
- Choose a broker that offers bonds. Look for brokers with a strong fixed-income offering, such as Interactive Brokers or Questrade.
- Open and fund your account. Complete account setup, submit required ID and deposit funds to your brokerage account.
- Request access to trade bonds (if required). Some brokers require separate approval for fixed-income trading.
- Research bonds. Check the bond’s issuer, maturity, credit rating, coupon and yield. Make sure it fits your risk and investment goals before purchasing.
- Place a buy order. Use the platform to submit a buy order at the current market price. You may also specify a limit price if you want to buy at a specific price.
- Monitor your investment. Track interest payments, maturity dates and changes in market value. Bonds can fluctuate in price if sold before maturity.
Examples of popular individual bonds:
- Government of Canada 10-year bond: A high-quality government bond backed by the federal government, offering very low risk and stable income for conservative investors.
- Royal Bank of Canada 5-year corporate bond: A mid-term corporate bond from one of Canada’s largest banks, providing higher yields than government bonds with only slightly higher credit risk.
- Toronto-Dominion Bank 3-year bond: A short-term corporate bond from another major Canadian financial institution, offering moderate yields and suitable for moderate-risk investors seeking stability over a shorter time frame.
Where to buy bonds in Canada:
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2. Buy bonds through ETFs or mutual funds
- Have an account with an online broker or bank. Both ETFs and mutual funds are widely available through major Canadian brokers and banks.
- Choose the right bond fund or ETF. Decide between government or corporate funds based on your goals and risk tolerance. Check the fund’s management fees (MER) and historical performance to make an informed decision.
- Find the ticker symbol or fund name. ETFs trade like stocks using ticker symbols, while mutual funds are purchased by fund name.
- Decide how much to invest. Determine the number of ETF shares or the dollar amount for mutual funds. Mutual funds often have minimum investment requirements.
- Place your order. For ETFs, submit a buy order during market hours. For mutual funds, orders are usually processed at the end-of-day net asset value (NAV).
- Monitor your investment. Keep track of the fund’s performance, interest distributions and fees.
Examples of popular bond funds:
- BMO Aggregate Bond ETF: A broad, low-cost fund holding a mix of Canadian and corporate bonds.
- Vanguard Canadian Aggregate Bond ETF: A diversified Canadian bond fund known for its low fees and wide market coverage.
- RBC Bond Fund: An actively managed fund investing in Canadian government and high-quality corporate bonds for steady, moderate-risk income.
Are bonds a good investment for young investors?
Bonds can be a good addition to a young investor’s portfolio, but they usually aren’t the main way to grow money. They’re lower-risk investments that provide predictable interest income and help preserve capital, which can protect your money during stock market downturns.
For young investors, it’s common to focus mostly on stocks for growth and hold a smaller amount in bonds for safety. Options like government bonds or investment-grade corporate bonds can provide steady income and balance your portfolio.
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.
Major rating agencies include DBRS Morningstar, Moody’s, Standard and Poor’s and Fitch Ratings. These agencies assign grades to help investors assess credit risk: higher ratings indicate lower risk, while lower ratings signal higher risk or “junk” status.
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:
- Visit fitchratings.com.
- Select the search tab.
- Enter the company name or the country you wish to find.
- Make sure to use the company’s full name — e.g., Ford Motor Company.
- 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
Bonds provide investors with predictable, regular interest payments, often referred to as coupon payments. This makes them attractive for people looking for stable cash flow, such as retirees or conservative investors. Since the payment schedule is set in advance, investors know exactly how much income to expect as long as their issuer doesn’t default.
Preserving capital
One of the main advantages of bonds is that the issuer repays the full principal amount at maturity, as long as they remain financially sound. As a result, investors are better able to preserve their capital, especially compared to stocks, which can fluctuate significantly in value. This makes bonds a good option for investors who need their money sooner or have a lower risk tolerance.
Diversification
If you already own stocks, adding bonds to your portfolio can help reduce overall risk. Stocks and bonds behave differently under different economic conditions; when one declines, the other may hold steady or even rise. Investing in both ensures your portfolio is better positioned to handle market ups and downs.
Liquidity
Although not all bonds trade frequently, many government and corporate bonds can be sold before maturity on the secondary market. This gives investors flexibility and access to their money if circumstances change. Liquidity varies by bond type, but for commonly traded issues, selling before maturity is typically straightforward.
Stability
Bonds can remain a reliable investment even when interest rates are climbing. While stocks often struggle in such environments, bonds continue to provide steady income and price stability in some cases. This makes them a useful tool for preserving returns and managing risk when borrowing costs and market volatility are increasing.
Bankruptcy priority
Compared to shareholders, bondholders have a higher claim on an issuer’s assets if the company enters bankruptcy. This priority doesn’t eliminate risk, but it offers an added layer of protection over owning stocks in the same company.
Drawbacks of bonds
Despite the advantages bonds have, there are some risks to consider.
Default risk
If the bond issuer runs into financial trouble, they may fail to make interest payments or repay the principal at maturity. Corporate bonds, especially those with lower credit ratings, carry a higher risk of default. Even government bonds, though typically very safe, aren’t entirely risk free.
Inflation
Inflation reduces the purchasing power of fixed interest payments over time. If inflation rises faster than a bond’s interest rate, the real return effectively becomes lower or even negative. This risk is particularly relevant for long-term bonds, where inflationary periods can significantly reduce their value.
Low liquidity
Not all bonds can be easily traded. Some issues, especially those from smaller corporations or municipalities, have limited buyers and sellers in the secondary market. When liquidity is low, investors may have difficulty selling without accepting a lower price.
Call risk
Some bonds are callable, meaning the issuer has the right to repay the bond before it matures. This typically occurs when interest rates fall, allowing the issuer to refinance at a lower cost. While this benefits the issuer, it disadvantages investors, who lose future interest payments and may have to reinvest their money at a lower rate.
Lower returns
Compared to stocks, bonds generally offer smaller returns over the long run. While they provide stability and income, this reduced growth potential can limit investors who rely too heavily on fixed-income investments.
Tax implications of bonds
The interest earned from most bonds is considered regular income in Canada and is taxed at your marginal income tax rate. This means that even if you don’t withdraw the interest, you still need to report it on your annual tax return.
However, if you sell a bond for more than you paid, you have a capital gain, and only 50% is taxed at your income rate. If you sell for less, you have a capital loss, which you can use to offset gains now, in the past three years or indefinitely in the future.
Consider keeping your bond in a registered account, like an RRSP for tax-deferred growth or a TFSA for tax-free growth.
Key terms to know related to bonds
| Term | Definition |
|---|---|
| Call feature | A feature that allows the bond issuer to buy back bonds at a set price in the future. Not all bonds are callable. |
| Coupon | A coupon is the annual interest rate paid on the bond’s face value. |
| Coupon date | This is the date when the bond issuer pays the interest rate to the bondholder, typically two times each year. |
| Credit quality | A measure of a company or government entity to pay its debt. |
| Default | A bond default is when the bond issuer fails to pay the interest or the principal back to the bondholder within the specified period. |
| Discount | A discount is when the bond’s price on the market is lower than its face value. |
| Face value | This is the bond’s value paid on the maturity date. |
| Par | Par is the same as face value. |
| Issuer | The company or government entity that issues the bonds. |
| Junk | A term used for high-risk bonds. |
| Maturity date | The date when the bond issuer has to repay the principal back to the bondholder. |
| Premium | This is when the bond is priced higher than its face value on the secondary markets. |
| Price | The present market value of a bond, which may differ from the face value. |
| Principal | The amount of money the bond issuer has to pay to the bondholder on the maturity date. |
| Yield | This is the return an investor would earn on a bond investment. |
| Primary market | Where bonds are sold for the first time directly by the issuer to investors. |
| Secondary market | Where investors buy and sell bonds (or other securities) after their initial issuance. |
Bottom line
Bonds are a reliable way to earn interest and preserve capital, making them a useful tool for diversification and stability in a portfolio. Choosing the right bond type for your investment goals and risk profile can help maximize returns while managing risk.
Frequently asked questions
Sources
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