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Bond
Basics
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.
Principal
amount
$1000.00
Year 1 (6% interest
on $1,000)
$60.00
Year 2 (6% interest
on $1,000)
$60.00
Year 3 (6% interest
on $1,000)
$60.00
Year 4 (6%
interest on $1,000)
$60.00
Total principal and
Year 5 (6%
interest (at maturity
interest on $1,000) date of 5 years)
$60.00
$1,300.00
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.