BondBasics

What is a bond?

You've just loaned your neighbour $1,000 so that he can renovate his home. He's promised to pay you 6% interest each year for the next 5 years, and then he’ll give you back your money.

 A bond works much the same way – you give a company $1,000 and they pay you a fixed rate of interest for a specified period of time, after which they return your principal. Governments (federal, provincial and municipal) and corporations use bonds to raise the capital they need to expand.

Making money:Interest and capital gains

There are two ways to make money from a bond – either by earning interest or capital gains.

Let's say that you have a $1,000 bond that pays 6% interest for five years. If you hold that bond until the very end of this term (known as the maturity date), you’ll collect five interest payments of $60 for a total of $300.

$60.00

Year 1 (6% intereston $1,000)

Year 2 (6% intereston $1,000)

$60.00

Year 3 (6% intereston $1,000)

$60.00

Year 4 (6%interest on $1,000)

$60.00 $60.00

Year 5 (6%interest on $1,000)

$1,300.00

Total principal andinterest (at maturitydate of 5 years)

Principalamount

$1000.00

You could also decide to sell that bond to someone else for $1,100. In that case you’d earn a capital gain of $100 (plus whatever interest payments you had received in the meantime). Now, why would someone pay you $1,100 for a bond that only cost you $1,000?

Selling bonds

Your $1,000 bond pays 6% interest. Since you bought that bond, however, interest rates have gone down. Similar companies are now only offering a 5% interest rate on their bonds. Your original rate looks pretty good to another investor. So you can sell that 6% bond at a higher cost than you paid for it, which is called selling for a premium.

However, if interest rates have gone up, and similar companies are now offering 8%, you may have to sell your bond for less – which is known as selling at a discount.

Interest rates and bond prices, then, are like a see-saw – when interest rates go down, bond prices go up (and vice versa).

Risk factors As we've seen in the previous slide, if you decide to sell your bond before the time is up, you’ll face interest rate risk. In other words, if rates have gone up, you may have to sell your bond at a discount.

If you decide to just sit tight and keep your bond until maturity, you don’t need to worry about interest rate risk. You’ll keep earning your 6%. You still need to be concerned about the company's ability (assuming you purchased a corporate bond) to keep paying interest.

If business isn't going well, the company might miss a payment. If things are really going badly, they might go bankrupt – meaning you stand to lose not only your 6% interest payment, but some or even all of your original investment.

Clearly a new, smaller company is going to have to offer a higher rate of return to attract investors. After all, why would you accept the higher risk if you could get the same rate from the federal or provincial government bond?

Easy evaluation: Ratings

Not sure how to evaluate the risks associated with a corporate bond? Don't want to go through the company’s annual reports yourself?

There are a number of independent firms that do nothing but evaluate the ability of bond issuers to make interest payments. Companies like Standard & Poor’s and the Dominion Bond Rating Service (DBRS) will issue a rating to each company, indicating their opinion of their ability to repay. For example, if DBRS gives a firm a "C," that means its bonds are very highly speculative and are in danger of default of interest and principal.

 You can visit these rating services at www.standardandpoors.com and www.dbrs.com.

Mutual funds A mutual fund is really just a basketful of investments. Investors don’t buy the actual investments, but rather buy shares, or units, of the entire basket.

Let’s say that the fund holds investments worth $100,000. If there is a total of 100,000 units in the fund, each unit would be worth $1.

If the value of the investments inside the fund were to go up to $200,000, each unit will now be worth $2. If you held 5 units, you would have earned $5.

Bond mutual funds A bond mutual fund, then, is basketful of individual bonds. A portfolio manager will buy and sell bonds inside that fund, trying to get the best possible rate of return for the unitholders. Advantage: Rather than putting all of your money into one individual bond, you can spread your risk over the hundreds of companies held inside that bond basket. It’s important to keep in mind, however, that because a portfolio manager is buying and selling bonds in the market (and therefore subject to the interest rate risk we discussed earlier), the fund could lose money in some years if the manager miscalculates.

Types of bonds and bond funds Bonds are usually categorized as being short (under 5 years), medium (5 to 10 years) or long term (more than 10 years). Which one you buy depends on your own goals and time horizon. Generally speaking, the longer the term of the bond, the higher the interest rate. That's because companies have to offer an incentive for investors to commit to a longer period of time.

Long-term bonds are great for someone looking for a reliable stream of income, but they're also more sensitive to changes in interest rates. If prevailing interest rates go up, the price of longer term bonds will go down further than short- or medium-term bonds.

While there are general bond funds, which will hold a selection of short-, medium- and long-term bonds, there are also funds that specialize in one type of bond. For example, it's possible to buy units of a fund that only invests in long-term bonds; the potential for returns is higher, but so is the risk.

Investor profile and taxation

There are bonds for every kind of investor. Someone who wants to speculate on new companies could buy higher risk junk bonds in the hopes of earning a high rate of return. A retired person, on the other hand, could buy a 20-year Government of Canada bond that would provide them with a very reliable and stable level of income. Important note to all bond-holders: Interest income is taxed at 100%. This means that bonds are great inside RRSPs, where investments are not subject to taxation until withdrawn, but held outside of an RRSP they may not be as tax-efficient as other types of investments.

Commissions and costs

Unlike stocks, which are traded on open exchanges, individual bond trades are made directly between buyer and seller. The commission you pay is calculated into the price of the bond – it's not charged on top the way it is on stock trades.

Bond mutual funds, on the other hand, are sold like any other mutual fund, and can be purchased with or without an upfront (or back-end) commission.

From here

If you’re interested in what bonds might be able to do for you, we should discuss and assess your investment comfort level and define what your personal goals are.

Once we’ve determined the level of risk you’re prepared to accept, I'll be able to either recommend an appropriate portfolio myself, or I'll refer you to a bond specialist.