Bonds are an important part of asset allocation, a mix of bonds and equities provide a better return than just one asset class this is known as the efficient frontier. Many believe the bond market is not as big as the equities market, this is far from the truth the bond market is at least 3 times the size of equity market.
Bond’s are somewhat more complicated to understand than equities so many novice DIY investors’ just focus on equities and leave bonds out of their portfolio’s. In here I will try to give some basics on bonds, what bonds are, different type of bonds, how bonds are affected and anything else important to bond investing.
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What is a Bond?
Bond is a loan either to a government or a corporation, in here we will mainly focus on corporate bonds, the issuer decides how much they need in loans, sets terms for the loan such as the length and interest rate and then goes to the market to get the loan, investors who agree to the terms of the loan provide the issuer with the loan and receive a bond certificate (nowadays electronically) they become the bondholder. It’s just like any other type of personal loan you may be familiar (student loan, mortgage etc.). There are two parties, the borrower and the lender, the borrower promises the lender to make interest payments on the loan and promises to repay the principle on a fixed date.
How do I make money with a Bond?
Bonds usually make regular interest payments to the bondholders this could be semi-annually, monthly, quarterly or any other interval the issuer has set. Issuers are legally obligated to make interest payments, unlike dividends it cannot be skipped or cut. You will be receiving a predictable amount of income on predetermined dates. When the bond matures you will receive the original amount, the par value, back from the company. The only type of bond not paying regular interest is a zero-coupon bond, you buy these types of bonds at a discount and will receive the par value at maturity.
Example:
On January 1st 2010 you buy $10,000 of Enbridge 5.5% 2015 Bond which pays semi annually on July 1st and January 1st. You would receive $275 on every July 1st and January 1st till 2015. On January 2015 you will receive your $10,000 back. Your total income was: $275 X 10 payments = $2075.
On January 1st 2010 you buy $7925 of BCE 2015 Zero-Coupon Bond at maturity will receive $10,000, with no interest payments.
You make the same amount in both cases only in a zero-coupon bond you do not benefit from the regular income.
Assumption: you buy the bond with no commission from the issuer and hold it till maturity.
Do bonds change in value?
Bond values depend on several factors, if you have bought the bond at par value and hold till maturity you will receive your full investment back. However bond price can fall or rise depending on couple factors:
Rating changes: There are several rating agencies that rate bonds (list provided at the end) these ratings can change over time which will change the bond price. If the Enbridge bond was rated AA by S&P when you purchased it and later was upgraded to AAA what do you think will happen to your bond price? Basically S&P are now saying that Enbridge is a stronger company and has a lower chance of default, this will increase your bonds market value, if you decide to sell the bond in the market before maturity you can now ask for a higher price than what you paid say $11,000 instead of the $10,000 and the $1000 will be capital gain. If rating agencies downgrade a company than the opposite will happen. However if you hold till maturity and the company is not insolvent you will receive $10,000 not more or less.
Interest Rate: Bond prices and interest rates have an inverse relationship, meaning that when interest rates rise bond prices will drop and when interest rates drop bond prices will rise. If you bought an AAA bond with 5.5% coupon and now AAA companies issue bonds with 6.5% coupons nobody will buy the lower paying bond off you for the same price, they will want a lower price so that overall return is comparable.
Those are two important factors affecting bond prices, there is also the general market risk and other general risks that are associated with any investment.
Are Bonds safe?
Safety is always a concern with any investment and there are many different types of risk, the risks associate with bonds are:
Default risk: Bonds are backed by full faith and credit of the issuer, however there is a chance that the issuer will fail on interest payment which will force them into bankruptcy. Note if the company is forced into bankruptcy bondholders are among the first with claim on assets, shareholders are last. By being a bondholder you are ranked higher than shareholders.
Interest rate risk: If you buy a bond with low coupon (interest payment) you will lose out when interest rates rise and bonds issue higher coupons.
Reinvestment risk: If you buy a bond with high coupon rate you may not be able to reinvest the income at the same rate.
Although other risks are associated with bonds, these are the top three you should be concerned with.
How are bonds taxed?
The coupon payments from bonds are taxed as income at your marginal tax rate. If you buy a bond in the secondary market at a discount and hold till maturity than the difference between your purchase price and par value (maturity value) is treated as capital gains, except with zero-coupon bonds where the differnce is treated as income. Bonds are not the most tax efficient investment vehicle, but yet an important part of your portfolio. You can hold them in your RRSP or TFSA to make them more tax efficient.
For more in investment taxaxtion.
What do you think about bonds?
Bond Rating Agencies:
Dominion Bond Rating Services (DBRS)
Ray is an ex-financial adviser and the founder of Financial Highway. Currently working in the financial industry and working towards completing his Chartered Financial Analyst, CFA, designation.