When you're in a near decade long bull run like we had been in prior to the 2020 crash, it's easy to go overweight on equities and underweight on fixed income.
However, those who were overweight equities at the start of 2020 faced significant volatility as the COVID crash sent stock prices plummeting in the quickest fashion in history.
Those who had exposure to fixed income, whether it be annuities, debentures, bonds, GICs, or treasury bills, saw that part of their portfolio remain somewhat stable.
Even better, those who owned bonds prior to the stock market crash in March of 2020 saw their bond prices rise as interest rates plummeted in an attempt to keep the economy afloat.
So, it's likely you've come here to learn how to buy bonds. And fortunately, I'm not only going to tell you how to buy bonds, but we will talk about many other concepts and strategies around the most popular form of fixed income.
It's important to keep in mind however that the attractiveness of bonds is greatly impacted by current interest rates, and it's very important that you not only learn about bonds, but how to buy stocks as well.
Depending on when you're reading this, although this article will always remain relevant, the decision to buy bonds is always changing.
Without further ado, lets get started.
What is a bond in simple terms?
The loan is then given a term (length) and what they call a "coupon rate" which we will discuss later, but in short the coupon rate is essentially the interest you earn on your loan.
As a bondholder, you have priority over equity (shareholders) in the event of insolvency of the company. This means that if the company were to go bankrupt, if there is any remaining capital from paying creditors with higher priority, you would be paid out prior to a common or preferred shareholder.
Typically, in the event of insolvency, there is often little left to be paid out to common shareholders.
However, it's important to note that as a bond holder, you have no rights to future earnings in the company, as you would a common shareholder.
So, a bond will ultimately end up with an investor getting interest payments from the issuer of the bond over the set maturity of that bond, and once the bond matures (the term is over) the investor will be paid back their initial investment.
What's the difference between a bond and a debenture?
However, it's possible you're actually buying a debenture. Something commonly grouped in under the term "bond."
So what exactly is a debenture?
Well, a debenture is similar to a bond in the fact you're loaning money to a corporation, and the corporation in turn will return you your principle plus semi-annual interest payments.
However, the difference between the two is primarily what is tied to the loan. With a debenture, you're essentially banking on the fact the corporation will be true to its word, and repay its debt. There is nothing tied to a debenture.
A bond however, will have an asset backing the loan. If the company is unable to satisfy interest or principle payments, the asset can be liquidated to make the payments.
Because a bond is asset backed, companies can generally offer lower interest rates than with a debenture.
Think of it this way. A line of credit from your bank is the bank depending on you making payments on both interest and principle.
However, a HELOC (Home Equity Line of Credit) is the same type of loan, where you put the equity in your home up as collateral.
As a result, an interest rate on a HELOC will generally be lower than a regular line of credit, due to its lower risk profile to a bank.
How do bonds work?
As I've stated before if a government, corporation, or municipality needs to raise capital for any reason, they can issue bonds.
In the case of a government or municipality, considering they don't have equity like stocks, offering debt is one of the only ways for them to raise capital.
So, they issue bonds.
A bond will have a par value, and a coupon rate. We'll go into more detail on what each of these are, and most importantly how the coupon rate differs from yield, later on in this article.
For now, just understand that when you purchase a $10,000 5 year Government of Canada bond with a 3% coupon, you're essentially loaning the government $10,000 and in turn the government is saying they'll pay you 3% annually until maturity.
How often do bonds pay coupons?
If we use the example from above, if you purchased a $10,000 5 year Government of Canada bond with a 3% coupon, you're going to receive $150, or 1.5%, every 6 months.
The date at which you're paid interest is dependent on the bond itself.
And, interestingly enough, it's likely if you purchased a bond on the secondary market instead of purchasing a new bond, you bought it in between coupon payments.
If this is the case, you'll likely owe the seller the price of the bond plus accrued interest, which can be calculated based off the coupon payment date. If you're the seller of a bond, you would receive the dollar amount you're selling the bond for, plus accrued interest.
What are the 5 types of bonds?
Floating rate bond
A floating rate bond is one where the coupon rate fluctuates dependent on interest rates. As we'll see later on in this article, bonds are inversely related to interest rates, so a floating rate bond can be good to lower overall volatility.
Keep in mind however, that floating rate bonds typically offer lower coupons than fixed rates, primarily because its coupon will move with interest rates, taking away some of the risk.
Fixed rate bond
Fixed rate bonds are ones where the coupon rates stay the same throughout the duration of the bond. If the coupon rate on a 10 year bond was 3% when it was issued, it will be 3% 10 years later.
Zero coupon bond
A zero coupon bond is one that does not pay a coupon. Instead, you purchase the bond at a deep discount to its face value, and when the bond matures you receive its face value, and thus a capital gain. This may seem confusing at first, but when we talk about bond pricing further on in the article, it will make sense.
An extendable bond is a bond that can be extended in term at particular intervals throughout its life. For example, if you have a 5 year bond that pays a 5% coupon and interest rates are currently declining, an extendable bond would allow you to extend that 5 year maturity term to take advantage of a higher coupon rate.
As you probably guessed, a retractable bond is the exact opposite of a extendable bond. Often issued with longer maturities, a retractable bond gives the bond holder the option to retract, or shorten the maturity of the bond.
A convertible bond allows a bond holder to request their bond be converted to common shares of a company. These bonds have a fixed interest rate and a definite date where principle must be repaid. However, they give an investor the option of converting it to shares of a company at specific prices, depending on the date.
How do I buy a bond?
In order to purchase a bond today, all you need is a discount brokerage account. In fact, Questrade even goes as far as commission free bond purchases as long as you buy more than $5000.
A brokerage like Questrade will have a Bond Bulletin, in which it will give you a detailed list of bonds, GICs, and other fixed income investments that you can trade.
Now, this is if you want to purchase a bond directly. It's 2020, the year of convenience, and if you're looking for an even easier way to buy bonds, you can look to bond ETFs.
Bond ETF's are an exchange traded fund that only contains bonds, and maybe a small allocation of cash. These ETFs purchase corporate and government bonds with a wide variety of maturities and then sell the ETF units to individual investors. One of the more popular bond ETFs here in Canada is XBB.
How does the pricing of a bond work?
When looking at the price of a bond, 100 is your par value.
If you bought a $10,000 bond and it currently trades at $10,000, it will be listed as 100.
However, if your bond decreased in value, lets say to $9700, if you decided to sell your bond, it would be listed as 97.
This means that the buyer will pay $97 for every $100 in par value of the bond.
If your bond increased in value to $10,300, it would be listed as 103 and a buyer would pay $103 for every $100 in face value.
Bonds can be sold in extremely high dollar amounts. So, this simple pricing structure makes it easier to quote and value bonds.
Are bonds a good investment?
Both can definitely coincide however to create a well blended portfolio that reduces overall volatility.
Bonds have historically underperformed stocks, except for a few particular instances in the past. So, most investors get the idea that they always have to chase after the best performing assets.
With the large majority of investments, the higher the rate of return you'd like to achieve, the higher your risk.
This is exactly why a treasury bill is considered zero risk. It's guaranteed, without exception, by the government. However, this is also exactly why it pays next to nothing.
When push comes to shove, an investment in common stocks has an infinitely higher chance of going to 0 than a treasury bill does. And as a result, common stocks have significantly higher returns.
An investment in bonds is not without risk, at least on the corporate side. A company can default on debt. However, if you're buying high grade bonds, this is extremely unlikely.
This reduced risk is why investors hold bonds. During events like the 2020 market crash, bonds reduced the volatility of many portfolios.
In fact, if we look to XBB, which is an iShares Canadian Bond ETF, during the march crash it saw a 11% drop in price while the TSX plummeted 35%.
Can you lose money on bonds?
As a result, it is possible to lose money by purchasing a bond and selling it at less than you paid.
It's also possible to lose money on bonds if the company were to default on debt. Many investors run into this trouble by chasing what we call "junk bonds", or bonds from lower credit companies that offer higher interest rates, albeit significantly more risk.
Bonds are, in most situations, safer than common stocks. However, if you're new to bonds don't get the illusion that your money is completely safe in a bond, or that returns are guaranteed.
Should you buy junk bonds?
They are typically companies with poorer credit ratings, and as a result have to offer higher coupon rates to attract investors. For example, the coupon rate on a 5 year bond of a small cap company that is heavily indebted is going to be much higher than the coupon rate on a 5 year bond of a popular utility company like Fortis.
However, you need to understand that the risk of that small cap company defaulting on debt is significantly higher than a blue-chip high grade bond.
Are bonds safer than stocks?
However, one can eliminate most interest rate risk when an investor purchases a bond and holds it to maturity, not worrying about fluctuating bond prices.
The price of your bond will fluctuate as interest rates move, and as a result your bond could be worth more, or less as time goes on.
So overall, a high quality bond, purchased and held to maturity, will almost always present less risk to an investor than a common stock.
How do bonds make money?
The first would be to purchase a fresh bond, and collect the coupon payments until maturity. At that point, you'll receive your initial capital back, and you'll have collected your interest along the way.
The second would be to purchase a fresh bond, and sell it on the open market for a capital gain. This would typically happen if interest rates had fallen since you purchased the bond. We'll go over this further in the article.
The third would be to purchase a bond on the secondary market for less than par value. This would typically happen if the bond was issued at a lower coupon rate than what is available now, making the bond less attractive, and thus trading at a discount. When the bond matures, you'll be paid back the par value, and realize a capital gain.
What are the disadvantages of bonds?
Interest rate risk, credit risk and the fact they are non favorable come tax time.
Bonds have an inverse relationship to interest rates. This means that when interest rates go up, your current bond portfolio will decrease in price. And when rates go down, your bonds will increase in value.
The reason for this is simple. If the going coupon rate for a bond right now is 5%, if interest rates rise by 1% and new bonds are currently offering 6%, your bond is no doubt less attractive.
If investors are going to buy the bond off of you, they're not going to pay full price. Why would they, they could just buy a new issue for par value and a higher coupon!
Credit risk is also another major concern for bond holders, as there is always the risk that companies will not be able to pay their debts, resulting in a default on the coupon or maturity payments.
And finally, the interest income from a bond is fully taxable, making a bond tax wise less favorable than a common stock.
When we look at things like common stocks, gains from the stock itself are taxed favorably in the form of capital gains, and the dividends from that stock likely qualify for the dividend tax credit.
Should I buy bonds when interest rates are falling?
The best way to reduce the overall volatility and fluctuating prices of a bond is to simply own it to maturity. Purchase the bond, collect the coupon payments and receive your initial capital back at maturity.
This way, the natural fluctuations of your bond holdings due to interest rate rises and/or drops won't phase you, and won't cause you to make incorrect decisions.
Bonds are completely normal to buy in both rising and falling interest rate environments.
The quicker the drop however, much like we saw in 2020, the more volatile.
What's the difference between bond yield and bond coupon?
In fact, most bonds you see will highlight the current yield of the bond. So what's the difference?
Well, a bond's coupon is simply the rate of interest it will pay on an annual basis, while the yield of a bond is the rate of return you'll see from purchasing the bond.
A bond with a $10,000 par value and a 6% coupon that is currently selling at $9700 still has a coupon of 6%. That will never change.
You'll receive semi annual interest payments of $300 from your $9700 investment.
However, as you can probably tell, the yield on this bond is not 6%.
The current yield on the bond is its coupon rate, compared to the price you'll pay. In this instance, you'll be making $600 in annual interest off a $9700 purchase. So your yield is 6.18%.
We can go even more in depth on this when we start talking about yield to maturity. However, I just wanted to provide you with a quick explanation on why yields are different than coupons.
The yield of a bond will have an inverse relationship to the face value of the bond. If the bond is above face value, its yield will be lower than its coupon. If the bond is below face value, its yield will be higher than its coupon.
Are there capital gains or losses on a bond?
Now, this is true if you were to purchase a brand new bond at face value.
What if you purchase a bond from someone else on the secondary market? Well, you may be hit with a capital gain, or even capital loss on maturity.
If you want to purchase a bond on the secondary market right now, it's likely these bonds are trading at a premium. This is because interest rates have fallen, and previous bonds offer a more lucrative coupon than new.
So, a generic example, it may cost you $10,500 to buy a $10,000 bond right now. So what happens when the bond matures? Well, you only get $10,000 back.
And as a result, you'd be able to file a capital loss for $500.
The opposite is true as well. If interest rates start to rise, it's likely new bonds issued at the time of writing will decrease in value, as their coupon rates are not as lucrative as new issues in a rising interest rate environment.
So, if you purchased a bond with a $10,000 face value for $9,500, you'd get $10,000 back at maturity.
This would trigger a $500 capital gain.
It's extremely important to factor in both capital gains and losses when purchasing bonds.
Overall, bonds are reserved for risk averse investors
With bonds, investors are sacrificing returns for preservation of capital.
As a result, bonds are mostly purchased by those nearing retirement, in retirement, or those who are extremely hesitant to take risk when it comes to their capital.
A prime example of a risk averse investor would be someone who is currently waiting to purchase a home.
If they're predicting that housing prices may fall or interest rates might continue to drop, they may choose to invest the down payment into a short term bond to gain some interest while they wait.
Not to mention, if they're correct in their assumption that interest rates would continue to drop, the price of their bond would increase.
If you're looking to invest in bonds, it's critical you understand that unless you're investing in junk bonds, you're likely going to be sacrificing returns. Yes, your money will be safer, but your money will also not be growing at the rate it would be if it were invested in common stocks.