Buying a bond means that you are lending money to a company or a government (the bond issuer). The loan will be for a set period of time, which is called the term. Over the term of the bond, the bond issuer will typically pay you interest. For example, many bonds have an interest rate that does not change over the term of the bond, which is called a fixed interest rate. At the end of a bond’s term or maturity date, you can expect to receive back the original amount of money loaned, plus the interest accumulated on that loan over the term.
For example, if you invest $10,000 in a Canada Savings Bond with a fixed interest rate of 1%, and a term of 1 year, then at the end of that term you can expect to receive back the original $10,000 loaned, plus $100 in interest.
In general, when interest rates go down, bond prices go up, and vice-versa.
Types of Bonds
In Canada, all levels of government – municipal, federal, and provincial – issue government bonds. The federal government also issues Treasury Bills and Canada Savings Bonds.
Treasury Bills (a.k.a. T-Bills) typically have shorter terms (less than one year) and pay a lower interest rate than government bonds. You do not receive regular interest during the term; instead you buy at a discount to the principal amount of the bond and receive the principal amount at the end of the term.
Canada Savings Bonds and Canada Premium Bonds
Canada Savings Bonds (CSB) and Canada Premium Bonds (CPB) are different from other government bonds in five important ways:
- You can buy them in smaller amounts, as low as $100.
- The government resets the interest rate it pays on the bond every year.
- You can cash in your CSBs and CPBs at any time.
- You can only buy CSBs in October and CPBs in October and November.
- Both CSBs and CPBs normally pay a lower interest rate than other government bonds.
A corporate bond is a loan that you make to a company where the loan is secured against specific company assets as collateral for the loan. In return for the loan, the issuer will typically pay you interest. Corporate bonds commonly pay a higher interest rate than government bonds. Companies can also sell debentures. Debentures are similar to corporate bonds, but the loan is not secured against company assets as collateral for the loan.
These bonds are created when a bond issuer separates the interest payments and the principal of a loan and sells those investments separately. The strip bond entitles you to a single payment when the interest payment or principal amount becomes due.
What Risks do They Have?
With both corporate and government bonds, one risk to consider is that the rate of inflation may be higher than the interest rate paid by a bond, which would mean that your investment isn’t keeping up with the cost of living.
Another risk to consider is that a particular bond issuer may not have enough money to repay their loans, which may result in the bond issuer defaulting on their bond. If this occurs then you may lose some, or all, of the money you invested. Bonds that are more likely to default often pay a very high interest rate. These bonds are often called high-yield bonds or junk bonds.
Finally, there is a risk that you’ll lose money if you sell a bond before its maturity date and the price of the bond has fallen.
Speak to your financial advisor to learn more about the risks of investing in bonds.
Can You Sell Them Easily?
Possibly, it depends on the bond you own. Generally, bond issuers will not buy back their bonds before the maturity date for the bonds. In addition, most bonds do not trade on an exchange.
Speak to your financial advisor about the options you have for selling your bonds.
What are the Costs?
Generally, your investment advisor will sell you a government or corporate bond from the firm’s inventory. If so, the price will contain a mark-up to cover the firm’s costs. If the investment advisor acts as your agent in the over-the-counter market, you may also have to pay a commission.
Strip bond prices contain a mark-up to cover your investment advisor’s costs based on the face value of the bond. You will likely pay the same amount of mark-up per $100 of face value even if you are purchasing a strip bond at a deep discount.
What are Expected Rates of Return?
Generally speaking, the expected rate of return for a bond is related to the amount of risk associated with that bond. For example, government bonds tend to be less risky than the bonds issued by companies. As a result, companies tend to pay higher interest rates on their bonds than governments do. Similarly, bonds with later maturity dates and strip bonds tend to pay higher interest rates than bonds with a shorter term to maturity and bonds that pay interest throughout the term.
Furthermore, the expected rate of return for bonds is lower than the expected rate of return for stocks. Again, this difference in the expected rate of return is related to the risks associated with those different investments – bonds tend to be less risky than stocks.