Bonds are a kind of fixed income security. When you buy a bond you’re lending your money to the issuer for a period of time, in exchange for a return on your investment. Find out more about how bonds work and how you can make money by investing in bonds.
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What are bonds?
Bonds are a type of fixed-income investment. When you buy a bond, you’re lending your money to a company or a government (the bond issuer) for a set period of time (the term). In return, the issuer pays you interest.
The term can be anywhere from less than a year to as long as 30 years. On the date the bond becomes due (the maturity date), the issuer is supposed to pay back the face value of the bond to you in full.
Fixed income securities are one of the three main types of asset classes, which include: cash or cash equivalents such as GICs; equities or stocks, and fixed income investments.
How do you make money investing in bonds?
There are two ways to make money on bonds: through interest payments and selling a bond for more than you paid.
1. Bond interest payments
With most bonds, you’ll get regular interest payments while you hold the bond. Most bonds have a fixed interest rate that doesn’t change. Some have floating rates that go up or down over time. On the bond’s maturity date, you’ll get back the face value.
For example, let’s say you buy a 10-year Government of Canada bond with a face value of $5,000. And the bond pays a fixed interest rate of 4% a year. If you hold the bond until it matures at 10 years:
- You’ll get back $5,000.
- You’ll get back 4% in interest, or $200, a year.
- Your return will be about $2,000 over 10 years ($200 x 10).
Floating interest bonds match the interest rate on three-month Treasury bill (T-bills). They pay interest quarterly. If the T-bill rate goes up, you get more interest on your bonds. If the T-bill rate drops, you get less interest.
2. Selling a bond for more than you paid
In general, when interest rates go down, bond prices go up. If this happens, you can make money by selling your bond before it matures. You’ll get more than you paid for it, and you’ll keep the interest you’ve made up until the time you sell it. Learn more about how interest rates affect bond prices.
Bonds can lose money too
You can lose money on a bond if you sell it before the maturity date for less than you paid or if the issuer defaults on their payments. Before you invest, understand the risks.
What are the types of bonds?
There are regular bonds and complex bonds. Complex bonds include strip bonds, index bonds, and real return bonds.
Regular bonds
You buy regular bonds for a set amount of money, for a set period of time. You get regular interest payments while you hold the bond. On the maturity date, you get back the face value of the bond. They’re issued by:
- the federal government
- government agencies (such as the Farm Credit Corporation)
- provincial governments
- cities (called municipal bonds)
- companies (called corporate bonds)
Complex bonds
Complex bonds have certain features that may improve the return on your investment. But they also have additional risks. Complex bonds include strip bonds, index bonds, and real return bonds.
1. Strip bonds
Strip bonds are created from regular government and corporate bonds. The principal amount and each interest payment are separated and sold as individual investments. You buy a strip bond at a discount. At maturity, you get the face value. The difference between the discounted value and the face value is your interest.
Strip bonds usually offer a higher yield than regular bonds with the same term and credit rating. This is because strip bonds do not make interest payments along the way that investors could reinvest or use as income. For this reason, strip bonds also tend to be affected more by changes in interest rates than regular bonds.
The secondary market (where investors buy bonds from other investors) for strip bonds isn’t as active as the secondary market for other bonds. You may not be able to sell your strip bond when you want to, or you may have to sell it for a lower price than you would like.
2. Index bonds
Index bonds keep pace with inflation. If the Consumer Price Index (CPI) goes up, so does the interest rate on your bond. On the other hand, because index bonds are longer-term bonds, changes in interest rates can affect their value more than other bonds.
3. Real return bonds
Real return bonds are issued by the Government of Canada and are also designed to keep pace with inflation. Twice a year, you receive interest payments adjusted to the CPI. When a real return bond matures, the amount you get back (the face value) is also adjusted for inflation.
For example, let’s say you buy a real return bond with a face value of $1,000 and it pays 3% interest. If the CPI goes up 1% after six months:
- The bond’s face value will go up 1%, from $1,000 to $1,010.
- Your interest payment for the first half of the year: $15.15 ($1,010 x half your annual interest rate = $1,010 x 1.5% = $15.15).
If the CPI goes up by 3% by the end of the year:
- The bond’s face value will go up 3%, from $1,000 to $1,030.
- Your interest payment for the second half of the year: $15.45 ($1,030 x half your annual interest rate= $1,030 x 1.5% = $15.45).
Your total interest for the year will be $30.60 ($15.15 + $15.45). A regular bond would have paid $30 interest. With the real return bond, you make an additional 60 cents to cover inflation.
What happens if you hold a complex bond outside of a registered plan?
There are tax disadvantages if you hold a strip bond or a real return bond outside a registered plan, such as an RRSP, a TFSA or a RRIF. Most investments are tax sheltered while you hold them inside the plan.
For strip bonds held outside a registered plan, at tax time each year, you’ll have to calculate how much interest you earned and pay tax on it. Even though you won’t get the money until the bond matures. This is because even though you don’t receive interest payments on the strip bonds, you still earn interest annually.
For real return bonds, you don’t actually get the extra interest for inflation until the bond matures. But at tax time each year, you’ll have to calculate the extra interest you earned with inflation and pay tax on it.
How do you buy and sell bonds?
You can buy bonds from a registered investment representative (sometimes known as a stockbroker). Investment representatives work for investment firms (sometimes known as brokerage firms), which are also registered. You can buy and sell bonds through a full-service firm or a discount brokerage firm.
1. Open an account
You can open an investment account through a full-service or discount brokerage firm. You may also choose to open a registered account, such as an RRSP, a TFSA or a RRIF.
2. Place your order
You can give your investment firm instructions to buy or sell a bond in person, by phone or online. This is called placing your order. Tell the investment firm the name and amount of the bond you want to buy or sell. If it’s a new issue of bonds, the price is often the face value. Otherwise, you’ll buy or sell a bond at the current market price.
Once your order is filled, the investment firm will send you a record of the transaction by e-mail, fax or mail. It will confirm:
- What you bought or sold.
- The price you paid or received.
- Any accrued interest on the bond.
Anyone selling securities or offering investment advice must be registered with their provincial securities regulator unless they have an exemption. Check registration through the Ontario Securities Commission or Canadian Securities Administrators.
Learn more about working with an advisor.
What’s the difference between bonds and bond funds?
You can buy bonds on their own or as part of a bond fund. A bond fund is a mutual fund or exchange-traded fund (ETF) that has invested in several different bonds. These funds often have a specific focus, such as:
- Tracking a certain index, such as the DEX Universe Bond Index.
- Buying bonds from a certain country, like Canada or the United States.
- Buying government bonds.
- Buying corporate bonds.
Before you invest, read the fund’s prospectus to understand the fund’s approach to investing and the risks.
There are five main differences between bonds and bond funds.
| Feature | Individual bonds | Bond mutual funds and ETFs |
|---|---|---|
| 1. Choosing investments | You or your advisor chooses individual bonds. | A professional fund manager chooses individual bonds for the fund. |
| 2. Risk | Risk depends on the type of bond you invest in. More variety leads to better diversification. Unless the issuer defaults, you will get back the face value at maturity. | Mutual funds and ETFs are diversified – they hold many investments. But risk will vary depending on the number of and types of bonds held in the fund. More variety leads to better diversification. With a mutual fund or ETF, you could lose money. The value of most funds will change as the value of their investments goes up and down. |
| 3. Return | You know exactly how much interest you’ll receive and can calculate what your return will be, whether you hold the bond until maturity or sell it before the maturity date. | You generally won’t know how much you’re going to receive in any given year. This is because the fund itself doesn’t have a maturity date. Income from a fund fluctuates as the underlying bond investments change. Returns may be a combination of interest and capital gains. |
| 4. Buying and selling | You can buy and hold a bond to maturity and get back the face value, or you can sell it before it matures. Your ability to sell varies depending on the type of bond. Some types of bonds, like strip bonds, can be harder to sell than others. | You can buy and sell mutual funds on any business day. You can buy and sell ETFs on the exchange they trade on, on any trading day. |
| 5. Fees | Commissions are built into the price of the bond. | You may pay a sales charge when you buy or sell a mutual fund. You’ll usually pay a commission every time you buy and sell an ETF. Mutual funds and ETFs charge management fees and operating expenses (known as the management expense ratio or MER). |
Summary
Bonds are a type of fixed-income investment.
- You can make money on a bond from interest payments and by selling it for more than you paid.
- You can lose money on a bond if you sell it for less than you paid or the issuer defaults on their payments.
- When you buy or sell a bond, the commission is built into its price. The investment firm marks up the price of the bond slightly to cover the costs of selling the bond.
- There are regular bonds, and three kinds of complex bonds: Strip bonds, index bonds, and real return bonds.
- Strip bonds and real return bondsare usually better suited for tax-sheltered plans, like RRSPs, TFSAs or RRIFs, because of the way tax is calculated.
- You can buy bonds individually or as part of a bond funds.
- Bonds and bond funds work differently when it comes to choosing investments, risk, return, buying and selling, and fees.
