Types of Investments: Bonds

There are many types of investments available, each with its own characteristics and potential benefits. If you are considering investing in stocks, bonds, or any other investment product, it’s crucial to understand how they work. Knowing the ins and outs of these investments will empower you to make informed decisions that align with your financial goals.

Understanding an investment’s level of risk and how it fits with your portfolio goals is also crucial. Your investment portfolio is not static; it can and should change over time as your financial goals evolve. For instance, a young professional might focus on growth-oriented investments like stocks, while someone nearing retirement might shift towards more stable, income-generating investments like bonds.

No matter what investment path you choose, always remember to do your due diligence before you invest. 

Note that this is the first article in a nine-part series on different investment types. Stay tuned for more in the coming months.

Email address:

Your email address will only be used to send you our newsletters. You will not receive any promotional emails and you can unsubscribe at any time.

Leave this field empty if you’re human:

Bonds

Bonds are a way of lending your money in return for a certain rate of interest, offering a reliable stream of income. They can be issued by companies or the government (the issuer) and have a set period of time known as the term, which can range from less than one year to as long as 30 years. On the date the bond becomes due, known as the maturity date, the issuer is supposed to pay back the face value of the bond in full. This makes bonds a relatively stable investment compared to stocks.

You can profit from bonds in two main ways. First, by holding the bond until the maturity date and collecting the interest payments over time. These interest payments, known as coupon payments, are typically made semi-annually and provide a steady income. Second, you can sell the bond before it reaches maturity. If interest rates have fallen since you bought the bond, its price will likely increase, allowing you to sell it for more than you paid. This can result in a capital gain.

However, there is also a risk involved. You can lose money on bonds if you sell them for less than you paid. This can happen if interest rates rise after you purchase the bond, causing its price to drop. Additionally, if the issuer faces financial difficulties and defaults on the bond, you may not receive the expected interest payments or even the principal amount at maturity.

How to make money investing in Bonds?

Bonds offer two ways to earn: regular interest payments and potential capital appreciation (selling for a profit).

Bonds Interest Payments

With most bonds, you’ll receive regular interest payments while you hold the bond, providing a reliable income stream. Most bonds have a fixed interest rate, which remains constant throughout the bond’s term. However, some bonds have floating rates that adjust periodically, often linked to an index like the three-month Treasury bill (T-bills). On the bond’s maturity date, you’ll receive the face value of the bond back.

Consider this example: You buy a 5-year Government of Canada bond with a face value of $10,000, and the bond pays a fixed interest rate of 5% per year. If you hold the bond until it matures in 5 years, you’ll get back your initial $10,000 investment. Additionally, you’ll earn 5% interest annually, which amounts to $500 per year. Over 5 years, your total return from interest payments will be approximately $2,500 ($500 x 5 years).

Capital Appreciation

While bonds offer a fixed interest rate, you can also potentially earn a profit by selling them in the secondary market. For example, if interest rates decline after you’ve purchased a bond, its market value may rise. This allows you to potentially earn a capital gain if you choose to sell the bond before its maturity date.

Now, let’s consider floating-rate bonds. These bonds offer a twist: the interest rate is tied to a benchmark, such as the three-month Treasury bill (T-bill) rate. As a result, the interest payments you receive adjust quarterly based on the prevailing T-bill rate. So, if interest rates rise, you benefit from higher interest payments on your bond. However, if interest rates fall, you’ll receive lower payments.

Bonds, whether fixed or floating rate, can be an essential part of a diversified investment portfolio. Fixed-rate bonds offer predictability and stability, ideal for conservative investors seeking steady income. Floating rate bonds can provide inflation protection, as their interest payments adjust with market rates, making them attractive in a rising interest rate environment.

Types of Bonds

Bonds come in various forms, with regular options offering straightforward features. However, there are also more complex bonds, such as strip bonds, index bonds, and real return bonds, that cater to specific investment goals.

Regular Bonds

When you buy a regular bond, you’re essentially lending a set amount of money to the issuer for a specified period. In return, you receive regular interest payments over the life of the bond. These interest payments, known as coupon payments, provide a predictable income stream. On the bond’s maturity date, the issuer repays you the bond’s face value, ensuring that you get back your initial investment.

Bonds are issued by various entities, each carrying different levels of risk and return. The federal government issues bonds, often considered the safest due to the government’s ability to meet its debt obligations. Government agencies, like the Farm Credit Canada, also issue bonds, typically used to finance specific projects or support sectors like agriculture. Provincial governments issue bonds to fund regional initiatives, infrastructure projects, or general operations, providing slightly higher yields than federal bonds due to a marginally higher risk.

Municipal bonds, issued by cities, fund local projects such as schools, roads, and public utilities. These bonds can be attractive to investors looking for tax advantages, as the interest income is often exempt from federal and sometimes state taxes. 

Corporate bonds, issued by companies, tend to offer the highest yields among these options, reflecting the higher risk associated with business operations and market conditions. Companies use these bonds to raise capital for expansion, research and development, or other business activities.

Complex Bonds

Some bonds are more intricate and can potentially increase your investment returns. However, they also come with greater risks. Examples of these complex bonds include strip bonds, index bonds, and real return bonds.

Strip bonds

Strip bonds, also known as zero-coupon bonds, are derived from regular government and corporate bonds. These unique investment vehicles are created by separating the principal amount and each interest payment of a standard bond, and then selling these components as individual investments. When you buy a strip bond, you purchase it at a discount to its face value. Upon maturity, you receive the full face value of the bond, and the difference between your purchase price and the face value represents your interest income.

One of the key attractions of strip bonds is their higher yield compared to regular bonds with the same term and credit rating. This higher yield is a result of strip bonds not making periodic interest payments that could be reinvested or used as income. Instead, all the interest accumulates and is paid out at maturity. This feature makes strip bonds particularly appealing to investors who do not need immediate income and are looking for long-term growth.

However, the lack of regular interest payments means that strip bonds are more sensitive to changes in interest rates. When interest rates rise, the value of strip bonds tends to fall more significantly than that of regular bonds, making them a riskier option in a fluctuating interest rate environment.

Moreover, the secondary market for strip bonds is less active than that for other types of bonds. This lower liquidity means you might face challenges if you need to sell your strip bond before it matures. You could find it difficult to find a buyer, or you might have to sell the bond at a price lower than its current value.

Despite these risks, strip bonds can be a valuable addition to a diversified investment portfolio, particularly for investors seeking higher returns and who have a longer investment horizon. 

Index Bonds

Index bonds are a smart way to protect your investments from inflation. As the Consumer Price Index (CPI) rises, so does the interest rate on your bond, ensuring your returns keep up with the cost of living. However, it’s important to remember that index bonds are longer-term investments. This means their value can be more sensitive to changes in interest rates compared to other bonds. Despite this, their ability to adjust with inflation makes them a valuable addition to any long-term investment strategy.

Real Return Bonds

Real return bonds, issued by the Government of Canada, offer a unique investment opportunity designed to protect your money from the eroding effects of inflation. Unlike regular bonds, real return bonds provide interest payments that are adjusted according to the Consumer Price Index (CPI), ensuring that both your interest payments and the bond’s face value keep pace with inflation.

Here’s how they work: Twice a year, you receive interest payments that are calculated based on the adjusted face value of the bond. This means that as the CPI rises, so does the amount of your interest payments and the value of your principal. When the bond matures, you receive the face value adjusted for inflation, safeguarding your purchasing power over time.

To illustrate, let’s consider a real return bond with a face value of $2,000 and an annual interest rate of 4%. Suppose the CPI increases by 2% after six months. The face value of your bond would increase by 2%, moving from $2,000 to $2,020. Consequently, your interest payment for the first half of the year would be $40.4, calculated as follows: $2,020 multiplied by half of the annual interest rate (2%) equals $40.4.

If the CPI increases by another 3% by the end of the year, the bond’s face value would rise again, this time to $2,060. Your second interest payment for the year would then be $41.2, calculated by multiplying $2,060 by 2%. Over the entire year, you would receive total interest payments of $81.6 ($40.4 + $41.2). In comparison, a regular bond with the same face value and interest rate would have paid a fixed $80 in interest. The real return bond provides an additional $1.60 to account for inflation, illustrating its benefit in preserving your investment’s real value.

Real return bonds are particularly appealing for investors seeking a reliable income stream that adjusts for inflation. This makes them an excellent choice for long-term investments, especially for those planning for retirement. Inflation can significantly erode the purchasing power of your savings over time, but real return bonds offer a safeguard by ensuring that both your principal and interest payments grow with inflation.

Another advantage of real return bonds is their stability and security. Issued by the Government of Canada, they carry a low risk of default, providing peace of mind that your investment is secure. This is especially valuable in uncertain economic times when inflation can be unpredictable.

Moreover, real return bonds can play a critical role in a diversified investment portfolio. By including these bonds, you can balance the risks associated with other asset classes, such as equities, which may not perform well during inflationary periods. This diversification helps to protect your overall portfolio from inflation-related volatility.

However, it’s essential to consider your financial goals and risk tolerance when investing in real return bonds. While they offer inflation protection and stability, their returns may be lower compared to other investment options, such as stocks or corporate bonds, especially in low-inflation environments. Therefore, it’s crucial to assess whether the inflation protection they provide aligns with your broader investment strategy.

Tax Treatment of Complex Bonds in Non-Registered Accounts

Investing in strip bonds or real return bonds outside of registered plans like RRSPs, TFSAs, or RRIFs can have significant tax disadvantages. While most investments are tax-sheltered within these registered plans, holding these specific bonds outside can lead to yearly tax complications and liabilities.

When you hold strip bonds outside a registered plan, you need to be aware of the tax implications. Each year at tax time, you’ll have to calculate the interest you’ve earned on the strip bond and pay tax on that amount, even though you won’t receive the interest payments until the bond matures. This is because strip bonds, despite not paying periodic interest, accrue interest annually, and this accrued interest is taxable each year. This means you’ll be paying taxes on income you haven’t yet received, which can complicate your tax situation and potentially reduce your overall investment returns.

Real return bonds also pose a similar tax challenge when held outside registered plans. These bonds adjust for inflation, increasing the principal amount and providing additional interest to account for inflation. However, even though you don’t receive the inflation-adjusted interest until the bond matures, you are required to calculate and pay taxes on this accrued interest each year. This means that annually, you must determine the extra interest earned due to inflation and include it in your taxable income, despite not actually receiving the cash until maturity.

To avoid these tax complexities and potential financial burdens, it’s generally advisable to hold strip bonds and real return bonds within registered plans like RESPs, FHSA (CELIAPP), RRSPs, TFSAs, or Registered Retirement Income Fund (RRIF). These plans offer tax-sheltered growth, meaning you won’t have to pay taxes on the interest earned each year, allowing your investments to grow more efficiently. Understanding these tax implications can help you make smarter investment choices and optimize your portfolio for better tax efficiency and overall returns.

Buying and Selling Bonds

Investing in bonds is a reliable way to diversify your portfolio and secure steady returns. Here’s a comprehensive guide to help you understand the process and take control of your financial future.

Step 1: Open an Investment Account

To begin, you need to open an investment account through either an online brokerage platform (e.g., Wealthsimple, Questrade, Desjardins Disnat, Qtrade, etc.) or your bank. Depending on your needs, you can choose between the two. Additionally, consider opening a registered account like a RESP, FHSA (CELIAPP), RRSP, TFSA, or RRIF. These accounts offer tax advantages that can enhance your investment returns over time.

Step 2: Place Your Order

Once your account is set up, you’re ready to buy or sell bonds. Placing an order can be done in person, over the phone, or online, depending on your preference and the services offered by your brokerage firm. To place an order, you need to provide specific instructions to your investment representative. Clearly state the name and amount of the bond you wish to buy or sell. If it’s a new issue of bonds, the price is typically the face value. For existing bonds, the transaction will occur at the current market price.

After placing your order, your investment firm will execute the transaction and send you a confirmation record via email, fax, or mail. This confirmation will detail what you bought or sold, the price paid or received, and any accrued interest on the bond. Keeping these records is important for tracking your investments and for tax purposes.

Step 3: Understand Registration and Regulation

Anyone selling securities or offering investment advice must be registered with their provincial securities regulator, unless they have an exemption. This regulation ensures that the individuals and firms you’re dealing with are qualified and adhere to industry standards. Before working with an investment representative, check their registration status (e.g., through the Ontario Securities Commission or the Canadian Securities Administrators). This step is crucial for your protection and peace of mind.

Additional Tips for Working with an Advisor

Choosing to work with an investment advisor can provide added benefits, especially if you’re new to investing or prefer a more hands-off approach. Here are some tips (but not limited to) to make the most out of your relationship with an advisor:

• Define Your Goals: Clearly articulate your financial goals, risk tolerance, and investment timeline to your advisor. This information will help them tailor their advice to your specific needs.
• Ask Questions: Don’t hesitate to ask questions about investment strategies, fees, and the reasoning behind their recommendations. A good advisor will be transparent and willing to educate you.
• Stay Informed: While an advisor can provide valuable guidance, staying informed about your investments and the market is crucial. Regularly review your investment statements and performance.
• Review and Adjust: Periodically review your investment strategy with your advisor to ensure it remains aligned with your goals. As your financial situation and goals evolve, your investment approach may need adjustments.