A bond is essentially a formal IOU. When a company or a level of government needs to borrow money, it may sell bonds to institutional and individual investors with a promise to make interest payments on the principal amount for a fixed term, which can be anywhere from a few months to 30 years or more. The rate of interest paid on the bond is the bond's yield. Once the bond reaches its maturity date (the end of the fixed term) the principal, or face value, is repaid to the investor.
Bonds are typically considered lower-risk investments for individual investors. In the traditional 60/40 balanced investing portfolio, bonds are meant to provide a stabilizing effect relative to the volatility of the stock market. However, not all bonds are low risk, so make sure you understand what you're holding in your portfolio.
How bonds work
In practice, buying a bond means lending money to a government or company under set terms. The borrower pays you periodic interest — known as a coupon — and at maturity, repays the face value you initially loaned.
For example, imagine you buy a $1,000 bond with a 4% coupon rate that matures in 10 years. Each year, you receive $40 in interest payments. At the end of 10 years, you get your $1,000 back.
While you hold the bond, its price can fluctuate on the open market based on interest rate movements:
When rates rise: your existing bond may become less attractive, so its price typically falls.
When rates fall: your existing bond may become more attractive, so its price typically rises.
If you sell before maturity, you might get more or less than the face value.
Bond terms to know
The bond market has its own vocabulary. Here are a few key terms you will likely encounter:
Face value: also called par value, the amount the bond is worth when it is issued and the amount the issuer promises to repay at maturity.
Coupon rate: the annual interest rate paid on the bond's face value
Yield: the return you can expect to earn on a bond, expressed as an annual percentage. Yield to maturity (YTM) estimates the total return if you hold the bond until it matures.
Maturity date: the exact day the issuer must repay the face value to the bondholder
Duration: a measure of a bond's sensitivity to interest rate changes. Longer-duration bonds are more affected by rate movements
Credit rating: an assessment of the issuer's financial health and ability to repay the debt, provided by rating agencies
Types of bonds
Bonds are generally categorised by who issues them. The issuer determines the bond's risk level and potential yield.
Bond type | Issuer | Risk level | HTypical yield |
|---|---|---|---|
| Government | Federal government | Very low | Lower |
| Provincial/Municipal | Provinces, cities | Low to moderate | Moderate |
| Corporate | Companies | Varies | Higher |
Some examples of bond types include:
Government bonds
Government of Canada bonds are generally considered low default-risk because they are backed by the federal government's taxing authority and ability to issue currency. Because the risk of default is very low, these bonds typically offer lower yields compared to other types.
The Government of Canada issues several types of debt securities, including:
Treasury bills (T-bills), which are very short-term debt securities with a maturity of 1 year or less
Government of Canada bonds, which have maturities ranging from 2 to 30 years
Real Return Bonds, which are indexed to inflation to help protect investors' purchasing power
Provincial and municipal bonds
Provincial bonds are issued by provinces and are considered relatively safe because provinces have steady income from taxes and other sources. However, they're not quite as safe as bonds issued by the Canadian government. People and companies buy these bonds to earn interest while helping provinces pay for things like schools, hospitals, and roads.
Corporate bonds
Corporate bonds are debt securities issued by companies to raise money for various purposes, such as expanding operations, funding research and development, or refinancing existing debt. They vary in riskiness based on the quality of the companies' earnings and future outlook. To compensate investors for taking on more risk, corporate bonds usually offer higher yields than government bonds.
Benefits of buying bonds
Bonds offer several advantages for investors:
Predictable income: regular interest payments provide steady cash flow
Capital preservation: you get your principal back at maturity
Lower volatility: bonds typically experience smaller price swings than stocks
Portfolio cushion: bonds can help offset stock market turbulence
Priority in bankruptcy: bondholders get paid before shareholders if an issuer goes under
Risks of buying bonds
Bonds are often viewed as a lower-risk asset class, but they still involve important risks.
Interest rate risk
Interest rate risk is one of the primary risks associated with bond investments. It refers to the potential for a bond's market value to fluctuate due to changes in prevailing interest rates.
Imagine you have a $1,000 bond paying 5% interest annually. If new bonds start offering 7% interest, your 5% bond becomes less attractive. To make someone want to buy your bond, you'd have to lower its price.
Longer-term bonds generally have more interest rate risk than shorter-term bonds.
Keep in mind that even when bond prices drop, the losses are only on paper if you don't sell. The bond continues paying interest and returns your principal at maturity.
Default risk
Default risk is the possibility that the issuer of the bond may not be able to pay back the face amount of the bond upon maturity. While bonds issued by the U.S. Treasury and the Government of Canada are generally viewed as having very low default risk, all other types of bonds do carry this potential risk.
Default risk varies based on the strength of the borrower and what happens in the economy in general. Investors are generally compensated for taking credit risk in the form of higher returns.
Inflation risk
The amount received upon the bond's maturity is fixed, as are the periodic interest payments. If inflation rises drastically, it cuts into the purchasing power of your returns.
Some bond types offer inflation protection: inflation-linked bonds adjust their principal with inflation, while floating-rate bonds have coupons that rise with short-term interest rates.
Bonds vs. stocks
Put simply, when you buy a stock you're buying an ownership stake in a company, but when you buy a bond you're becoming a financier of a loan.
Stocks and bonds offer different benefits:
Stocks: no guaranteed return, but you benefit from company growth through share price increases and potential dividends
Bonds: typically provide scheduled interest payments, with principal repaid at maturity if the issuer does not default.
Most people know stocks outperform bonds over the long term. But that doesn't mean you should hold 100% stocks.
Looking at 50 years of data, the benefit of adding more stocks to a portfolio declines after about 60-70% stocks. Beyond 80% stocks, the extra return rounds to zero because diversification reduces volatility, which helps compound returns over time.
The return to risk ratio peaks around 50% to 70% in stocks. After that point, the portfolio gains less and less from adding stocks and taking on more risk.
These patterns hold up across different market conditions. Bonds often perform well during hard economic times when stocks struggle, which is why they have insurance-like qualities and typically offer lower returns.
