What is a Bond?

Key Takeaways

  • Bonds are a loan between the investor and an issuer. The issuer of a bond will count the money received as “debt,” which is why bonds are classified as debt securities for the issuer.
  • While bonds might have lower short-term volatility than stocks, they are not exempt from risk.
  • Bond mutual funds are a common way to gain fixed income exposure, while lowering default risk.

When it comes to investing, two of the most popular asset classes are stocks and bonds. Bonds—sometimes referred to as fixed income—are a common investment option, especially for retirees. While bonds are common, not many people understand exactly what a bond is and how they work. In this article, we will describe what a bond is, common types of bonds and risks associated with owning bonds.

Fixed Income Basics

Bonds are loans between investors and institutions—often governments or corporations. When an investor purchases a bond, the issuer of the bond generally pays interest on an ongoing basis for a specified time period. By the end of that time period, the issuer of the bond will generally pay back the original investment amount, this is often called reaching maturity. Investors looking to gain exposure to fixed income can do so by purchasing individual bonds or shares of a bond mutual fund or exchange-traded fund. A bond fund is a collective investment scheme—similar to equity mutual funds—where multiple investors pool their money together and the fund invests in many underlying fixed-income securities.

Many corporate and government bonds are traded on secondary, over-the-counter (OTC) markets, while others may be purchased directly from the issuer. Organizations will often issue bonds to raise money when they are looking to fund new projects or refinance existing debt obligations. The initial price of the bond is usually set at par or face value. The price of each bond generally fluctuates based on the maturity date, credit quality of the issuer and the interest rate (often called the coupon rate) compared to the lending environment at the time the bond is purchased.

Types of Bonds

Bonds come in many shapes and sizes. Maturity dates, bond prices and yields all fluctuate depending on the issuer and the type of bond. Common bond types include:

  • Government Bonds or Municipal Bonds — All levels of government in Canada issue government bonds. Local government entities are responsible for Provincial and Municipal bonds, while the federal government is responsible for Government bonds. Government bonds are considered the safest bonds since they are backed by the federal government. While municipal bonds may be one of the most popular types, the government is also responsible for issuing Treasury bills.
  • Treasury Bills or T-Bills — Like municipal bonds, these bonds are issued by the government. The main distinction between government bonds and Treasury bonds is that length of time until maturity and interest rates. Treasury Bonds generally have shorter maturity periods (often under a year) and lower interest rates.
  • Corporate Bonds — As the name would suggest, these bonds are issued directly by corporations. Companies issue corporate bonds as a direct loan against company assets. Corporate bonds often have higher interest rates than government bonds, resulting in higher regular interest payments. 

Risks Associated With Bonds

Investing and risks go hand and hand. While most investors associate risk with stocks, fixed income is not exempt from risk. The following is an overview of some of the risks associated with investing in bonds.

  • Default Risk: This is the risk that bond issuer is unable to pay back their debt obligation. The less creditworthy the issuer, the higher their bond yields could be. The extra yield is often a way of compensating investors for taking on the extra risk. Risk in the bond market is measured with grades from agencies, such as Standard & Poor’s, Moody’s and Fitch Ratings Inc.
  • Liquidity Risk: Many corporate and municipal bonds trade infrequently, making them difficult to price and sell on the bond market. If you decide to sell a bond that is rarely traded on the market, the lack of liquidity could lead to selling at a discount.
  • Interest Rate Risk: Interest rates and bond prices are negatively correlated, so selling a bond before it matures in a rising interest rate environment could cause a loss.
  • Re-investment Risk: Holding a bond with high-interest payments until maturity may seem like a solid strategy, but many bonds are callable—meaning the issuer can decide to redeem (“call”) a bond before maturity. Often, an issuer will call a bond as interest rates fall, which means, as the investor, you may have to replace the called bond with a lower yielding one.
  • Inflation Risk: If inflation rises, holding a bond to maturity will reduce the purchasing power of your interest payments. In addition, the principal you receive at maturity may not have the same purchasing power as when you purchased the bond.

Estimating tax liability can be complicated as well, due to the differences between the different types of bonds, how they were purchased, and the specific tax treatment of the interest received. It may help to work with a tax adviser if you are concerned about the tax implications from trading bonds.

Ways to Invest in Fixed Income

There are many factors to consider before deciding to invest in bonds. What are your investing or retirement goals? What asset allocation will help you reach those goals? How long will you need your money to last? If you determine that bonds are right for you, there are a number of ways you can increase your fixed-income exposure.

One of the most common ways investors gain fixed income exposure is by purchasing a bond fund. Bond funds are generally hold a variety of bonds from different issuers—reducing the likelihood of default risk. You also have the ability to forgo the bond market and purchase government bonds directly from the government.

Determining an Appropriate Strategy for You

Investing is complicated. Despite the complexities that come with determining an appropriate retirement strategy, the good news is you’re not alone in this goal. Fisher Investments Canada helps investors develop retirement strategies and understand their retirement needs without selling high-commission investment products. If you are trying to determine an appropriate asset allocation or would like a second opinion on yours, give us a call today or download one of our guides today!

Investing in stock markets involves the risk of loss and there is no guarantee that all or any capital invested will be repaid. Past performance is no guarantee of future returns.