What are bonds?
Bonds are like a loan agreement or an IOU passed between strangers. One party pays money today to another party who needs the money. They do this with the agreement that tomorrow the borrower will pay back that loan with interest.
Bonds might be about as varied as dog breeds, but they’re all super formalized agreements. Unlike a stock, which makes no guarantees about fixed payments to its investors, a borrower, otherwise known as a bond issuer, sets out these terms to the lender, or bondholder. They do this the same way a mortgage or auto loan sets out all the terms at the home closing or car sale.
The length of time before the loan principal is due in full and interest (or “coupon”) payments stop is called the bond maturity date. The rate of interest the issuer agrees to buy the bondholder is called the bond yield. The handsome devil with the pistol under his tux is called Bond– James Bond—but you knew that last bit already.
Types of Bonds
Bonds are categorized by the entity that issues them. Government bonds are recommended as a stable investment offsetting more volatile stocks in a portfolio. Local governments issue municipal bonds. Companies issue corporate bonds. Generally, the less risky the bond issuer, the less interest, called a “coupon,” its bonds will pay.
The taxonomy of bond types begins with what sort of entity is issuing them. Is the US government selling bonds because it needs to service its various debts? Is Bob’s Waffle House issuing them because it’s hoping to add a drive-through to its Edmonton location? Since the issuer is the one on the hook to pay you, its identity and financial health is obviously extremely important. We don’t have time for all of the bond types but here are the biggies.
Government bonds: Government bonds, often referred to as Treasuries, are the Raisin Bran of the bond world—super reliable, but owing to their low-yield, not exactly the kind of thing that’s going to get anyone’s resting heart rate up. Because bonds are typically so stable, they are an excellent counterpoint to stock holdings. While stocks will provide amazing growth during bull markets, bond holdings will help provide a stable cushion so that portfolios don’t crater unnecessarily during bear markets. In fact, bonds can outperform stocks in downturns, that’s not to say we’ll see the same pattern in years to come. Stocks and bonds are like Mick Jagger and Keith Richards—their solo work’s okay, but they’re infinitely better when paired together.
Investment-grade corporate bonds: Companies with strong financials issue these bonds in order to scare up money fast for growth or to pay debt. In order for a bond to qualify for this status, they must be graded at the very least BBB by rating agencies. Although they could default, investment-grade corporate bonds are typically unlikely to default. Consequently, they feature yields that may not be dramatically different than Treasuries, and in economic downturns, treasuries may even offer higher returns.
High-yield bonds. Remember junk bonds? These are those. Any corporate bond with a rating below “BBB” gets lumped into this heap. They tend to perform more like equities than bonds. There has been a record-setting bull market, where high yield bonds performed particularly well for investors while investment grade bonds, not so much. Still, you’ll need a strong stomach to ride this tiger.
Municipal bonds Local governments—states, provinces, cities, and counties–issue their own bonds often to fund capital projects that they don’t have the cash on hand to finance. Maybe Saskatchewan’s been overrun with hoodlums and needs a new jail. They may issue a municipal bond, often called a “muni,” to build their new hoosegow.
Like corporate bonds, they come with ratings—either investment grade (dependable, low yield) or high-yield (higher risk, more possible upside.) Munis are especially appealing to high earning individuals with major income tax bills because unlike other types of bonds, their interest is generally exempt from taxes.
Munis are especially appealing to high earning individuals with major income tax bills because unlike other types of bonds, interest income paid on municipal bonds is exempt from federal tax. If you own municipal bonds issued within your state, then the interest income may also be free of state and often local tax.
Foreign bonds: This is a popular way for investors to hedge against the strength of the dollar and get higher yields than they might from treasuries. A foreign bond is defined as a bond sold by a foreign country or company in the currency of wherever it’s being sold.
Foreign bonds are not recommended for any but the most sophisticated investor. Since their interest is computed in the currency of the issuer, any unforeseeable blip that a foreign government might have, from political unrest to interest rate adjustments by a central bank can roil the market in unpredictable ways.
One major selling point for foreign bonds, they have the most adorable names imaginable. Foreign bonds sold in the UK are called “bulldog” bonds; in Australia, they’re called “matilda” bonds.
How to invest in bonds
Bonds may be complicated to understand but investing in them is easy. They can be purchased directly through the government, through discount brokerages, or best of all, packaged within diversified bond ETFs or mutual funds. Thrifty investors should consider having some bond holdings as part of their portfolio to counteract the volatility of stocks and other investments typically seen as higher risk.
Why do some bonds pay more than others? There are two primary factors which determine bond yield. The first factor is the maturity date. Investors expect to be compensated for tying up their money for longer periods of time, so in general, bonds with maturity dates that are further in the future pay a higher yield. Bonds are classified by their maturity date as short (a month to two years) medium (two to ten years) or long-term (any period longer than ten years.)
The second factor that determines yield is how likely the issuer is able to pay the bondholder back at maturity. The reputation of bonds has benefited immeasurably from the fact that US Government bonds, also called “treasuries,” are about the most dependable investment imaginable and some people imagine that all bonds are just as reliable. Not so! The universe of bonds is large, and there are some bond issuers that are deemed not-great bets for repaying their obligations at maturity.
How likely an issuer is to pay what it owes is expressed in the yield over a similar maturity government bond. It’s also expressed by the means of a bond credit rating which is determined by credit rating agencies like Moody’s. Like school grades, the closer to the top of the alphabet the rating is, the more likely the issuer is to pay it back, and the more times the letter is repeated, the better. An “AAA” bond rating is the absolute best. A “D” is the sad trombone of ratings, the lowest depths of bond default.
No investor, in her right mind, would ever accept the same yield for a gold-plated AAA bond and the inherent risk that comes with a rusty BB bond. Generally, the lower the rating, the higher the yield and the higher the rating the lower the yield.
You’ve probably heard of junk bonds. In the late Eighties, a guy named Michael Milken was the first person on Wall Street to earn a billion dollars over a four-year period. He set this record by specializing in super high-yield, high-risk junk bonds. (He also had a terrible toupee and went to prison for financial crimes, but that’s a tale for another day.)
What’s the difference between nominal and inflation-linked bonds?
Most bonds are considered nominal bonds. This refers to the fact that the interest, or coupon, is paid according to a pre-determined rate computed as a percentage of the principal.
An inflation-linked bond, sometimes called a real-return bond, on the other hand, computes its coupon tied to a pre-specified return rate plus the current rate of inflation—a factor which can be become particularly important in the case of long-term bonds, which can have maturities of 20 or even 40 years.
There’s one thing to remember, even nominal bonds include expected rates of inflation baked into them. Inflation-linked bonds are historically less correlated to equities than nominal bonds. This is because equities also tend to struggle when inflation is above expectations. It’s when inflation exceeds expectations that bondholders can lose financial ground. Diversification in investing is never a bad strategy, and many who are invested heavily in bonds like to hedge against inflation by dividing their holdings between nominal and inflation-linked bonds.
Where to buy bonds
You know what’s easier than understanding the different bond types and how they work? Speaking Chinese might be. Pretty much anything, actually. Bonds are hard.
But you know what’s objectively really easy? Buying bonds. You can go directly to Uncle Sam and buy any kind of Treasury you like. You can buy bonds through a discount online brokerage or investment platform.
If it’s diversity in bond holdings you seek (and diversification is always a good idea) you can buy an ETF or mutual fund that contains any flavour of bond you might desire. The better automated investing services offer an array of bond ETFs as part of their portfolios. The best of these services feature no minimum investment. to open any type of account.
We’re obviously a little biased, but we think Wealthsimple is the best home for a first-time bond investor or even an old pro. Sign up to Wealthsimple now and start investing or find out more details here.