What are bonds?
When we think about loans, we typically imagine receiving some amount of money (called the principal), paying interest, and eventually returning the entire principal back to the lender. With bonds, the roles are reversed. We provide a principal to a government or corporation; they pay us interest over an agreed-upon timeline, then they repay our principal at the end of the agreement (called the date of maturity). Corporations and governments issue bonds when they are in need of money, and they use that money to invest in their projects.
Bonds are categorized as ‘fixed-income securities’ because the amount of money you’ll earn from a bond is fixed once you’ve purchased it.
Risks
Bonds are generally considered less risky than stocks, but that doesn’t mean they’re free of risk. As a bond holder, your worst-case scenario is that the issuer can’t pay back your principal at the date of maturity. If you’re holding corporate bonds, this can happen if the company has gone bankrupt. Government bonds are generally safer, but if a government is going through a period of significant unrest, they may still find themselves unable to pay you back. Governments may strive to settle this problem by offering to pay you back less or to extend the date of maturity.
If you want to avoid these worst-case scenarios when purchasing bonds, you can consult a bond’s rating. Bonds are rated on a letter scale, with different organizations using slightly different systems. According to the S&P Global Ratings scale, the most secure bonds are rated AAA. Typically, this rating is reserved for stable government bonds (like Canadian bonds), although it’s not impossible for corporate bonds to achieve it. The scale continues: ‘AA,’ ‘A,’ ‘BBB,’ ‘BB,’ ‘B,’ ‘CCC,’ ‘CC,’ and ‘C.’ Bonds rated at ‘BB’ and below are often referred to as junk bonds, as their issuers are more likely to default.
You might be wondering: why would anyone invest in a junk bond, when the AAA Canadian government bonds are right there? The answer is that junk bonds pay much higher interest rates in order to compensate for their lower risk ratings. So, while the general consensus is that fixed-income securities are much safer than stocks, this assumption only holds true for highly-rated bonds.
How bonds react to interest rate movements
The Bank of Canada (BoC) determines the standard interest rate, which sends ripples through all of Canadian borrowing, including the rates that bond issuers set. Bond issuers provide a higher interest rate than the BoC because this makes their bonds more attractive to everyday investors; so, if the BoC raises the standard interest rate, bond rates rise right along with it. When the standard interest rate gets lowered, bond issuers lower their rate so that they aren’t paying more interest than they have to.
Are bonds redeemable?
When you purchase a bond, you and the issuer agree to a date of maturity, which is when you’ll get your money back. But what if you find yourself in a situation where you need the money sooner? The bad news is that the bond issuer will not give you back your money early; they have no obligation to do so, and they’ve likely already spent the cash. The good news is that you can sell your bond on the market to a buyer who’s willing to continue the bond agreement to the maturity date. The buyer will provide you with your principal amount, and they’ll continue collecting interest payments until the maturity date, at which point they’ll receive your original principal payment.
This might sound simple, but there’s one important snag: the standard interest rate set by the BoC may have changed between when you entered into your bond agreement and when you want to sell your bond. If the standard interest rate has gone up, then newly-issued bonds will pay higher interest rates than the bond you purchased a while back. It’s unlikely that someone will want to buy your bond at its lower interest rate, unless you’re willing to accept a lower principal in return; perhaps they pay you 90% of your initial principal in exchange for your bond.
Let’s look at an example. Imagine you’ve purchased a bond for $1,000 with a 6% interest rate and two years until maturity. After the first year, the standard interest rate has increased from 4.5% to 5%. You’ve decided to sell your bond and collect your principal early, but, because of the interest rate hike, newly-issued bonds offer investors a 6.5% interest rate; yours still only offers 6%. To compensate for this difference, you agree to sell your bond for $995. This allows the buyer to still capture a 6.5% gain; they’ll get a lower interest rate, but, once the date of maturity is reached, they’ll collect more money than they paid.
On the flip side, if the standard interest rate goes down after you purchase your bond, you suddenly have a more desirable rate. As a result, you’ll be able to sell your bond for more than your original principal.
Bond taxation
If you purchase bonds in a registered, tax-sheltered account (say, your RRSP or your TFSA), you don’t have to worry about taxes. But, if you hold bonds in a non-registered account, you’ll have to pay taxes on capital gains and interest earned from your bonds.
As discussed above, investing in bonds can lead to two outcomes: either the investor holds the bond to maturity and collects interest along the way, or the investor sells their bond for more or less principal than what they initially paid. If you collect interest, you’ll be taxed on the entire amount you receive (not unlike your employment income). If you choose to sell your bond, things work a bit differently. The difference between the principal you paid and the principal you receive for the sale is considered a ‘capital loss’ or a ‘capital gain,’ depending on the outcome. For capital gains on any securities (including bonds), you’ll only be taxed on half the amount. And if you have a capital loss, you can deduct half of that amount from your total capital gains on other securities when calculating your taxes.
To avoid being taxed on 100% of their income from bond interest, investors often choose to invest in bonds using registered accounts. And because capital gains are taxed more favourably, some bond enthusiasts search for cheaper bonds that have fallen in value, so that their overall bond profits are due to capital gains instead of interest.
Diversifying your portfolio with bonds
If you have your money managed for you, you might remember answering some questions about your appetite for risk. If you said you have a higher tolerance for risk, your portfolio likely contains more stocks than bonds. But if you prefer not to see large swings in your account balance, your portfolio probably contains more bonds than stocks. If your risk appetite is somewhere in between, the mixture between stocks and bonds will be more balanced. If you’re investing through your bank, most portfolio managers will invest in mutual funds that strike a suitable balance between stocks and bonds.
Stocks tend to have larger price swings, so it’s rare to see an entire portfolio of stocks. Portfolio managers will generally invest some money in stocks, and, instead of leaving the rest of the money in cash, they’ll put the remainder in fixed income securities. This allows the leftover funds to earn interest, instead of sitting idle. Investing in both stocks and bonds is also partially a hedge; if the stock market falls, bonds may increase in value. This is because, if the stock market falls due to a recession, the BoC may lower interest rates to encourage more spending in the market. As discussed above, lower interest rates increase the value of existing bonds. As an investor in both stocks and bonds, you may see your stocks fall in value during a recession, but your small consolation prize is that the value of your bonds may increase.
Are GICs the same as bonds?
Guaranteed Investment Certificates are another fixed-income security; like bonds, they provide regular interest payments in exchange for a principal (to be returned at the date of maturity). But GICs are different from bonds because they’re exclusively offered by banks and trust companies, and – as their name would suggest – they are guaranteed. Because of their low risk level, GICs almost always offer lower interest rates than available bonds.
GICs are not usually redeemable and must be held until maturity. It is sometimes possible to have your principal returned early, but this generally comes with penalties, including losing any accrued interest. There’s also no secondary market where you can sell your GIC to other investors. Interest earned from GICs is taxed like bond interest: 100% of it is taxed at your marginal rate.
Summary
Bonds allow investors to loan money to governments or corporations and collect regular interest. When investing in bonds, your biggest risk is that the issuer may not be able to make interest payments or pay back the principal. Different bonds have different risk profiles; the safest bonds are rated AAA, whereas the riskiest bonds are rated around a C. Higher risk bonds provide investors with higher interest rates.
If you don’t want to keep your bond until the date of maturity, you can also sell it on a secondary market. Depending on changes to the BoC interest rate, the bond may be sold at a loss or a gain.
