Bonds are a type of investment product that is less volatile than other investments, such as individual stocks.
As a fixed-income product, bonds appeal to investors who may use them to reduce the overall risk in their portfolios. How bonds fit into your investment strategy will depend on your goals, risk tolerance and time frame.
» GUIDE: Investing for Canadian Beginners
What is a bond?
When governments and companies need to raise funds, they sometimes issue bonds. Investors who purchase these bonds are essentially lending money to the bond issuer. In return, the bond issuer will pay back the loan, plus interest.
Bonds are appealing to some investors because they offer a fixed rate of return. Generally, short-term bonds pay a lower interest rate than long-term bonds.
Since bonds involve less risk than other investments, like stocks, the returns are typically lower. That said, some bonds pay a higher interest rate because the issuers may not be as creditworthy, so investors are taking more of a risk by buying those bonds.
Current interest rates can also affect bond returns. In a low-interest-rate environment, bonds will pay lower interest rates. Although investing in bonds may only yield low returns, there’s little chance you’ll lose money.
Types of bonds
Although all bonds are a type of fixed-income security, different types of bonds are available. The most common bonds include:
- Government of Canada bonds: These bonds are of the highest quality since they’re backed by the federal government.
- Provincial bonds: Although the credit rating of provincial bonds is typically not as high as Government of Canada bonds, their yields are usually higher.
- Municipal bonds: These bonds may have higher or lower yields than provincial bonds of similar quality due to their liquidity and other specific issues.
- Investment-grade corporate bonds: Corporate-issued bonds with a rating of “BBB-” or “Baa3” or higher are considered investment-grade. Corporate bonds are riskier than government bonds, but often offer higher returns.
- High-yield bonds: Bonds with a rating below “BBB-” or “Baa3” are non-investment grade and often referred to as junk bonds. While the high yield can be attractive, you have a much greater chance of losses than you would with higher-quality bonds.
- Strip coupons and residual bonds: Federal, provincial and municipal bonds have two components: interest payments (coupons) and the principal amount (residual). These can be sold as individual securities.
- Canada Savings Bond (CSB): Purchased through a payroll savings program, CSBs were guaranteed by the federal government and have a guaranteed interest rate. CSBs are no longer available for purchase.
How to buy bonds in Canada
Bonds may be purchased directly via a broker, such as your bank or credit union, or you can buy them through your own brokerage account.
Buying bonds directly
Anyone interested in buying bonds can go directly to their financial institution or licensed financial advisor. They’ll have a list of bonds available for you to choose from, and you can typically purchase bonds via phone, online, or even in person.
Many bonds require a minimum purchase amount. Your broker will also likely charge you a flat fee to make the purchase, which is usually included in the quoted price.
Once you’ve purchased the bond, any interest payments will be deposited in the account you designate. This account is also where the money will be deposited when your bond matures. If you need to sell your bond early, you’d have to contact your broker.
Buying bonds through your brokerage
Investors with brokerage accounts can purchase bond exchange-traded funds, or ETFs, which give you access to dozens of bonds in a single product. Bond ETFs are designed for different purposes, so you can choose a type or timeline that meets your needs.
Bond ETF prices will fluctuate depending on current market conditions. Most brokerages charge a fee for buying and selling ETFs. Bond ETFs also charge a small management expense ratio.
Interest payments typically happen monthly and are paid directly into your brokerage account. When bonds mature, the ETF manager will purchase new bonds to generate additional income.
Pros and cons of bonds
Although bonds are typically low-risk investments, they still come with advantages and disadvantages. Consider both before deciding how to invest.
Pros of bonds
- Low risk: Government and investment-grade bonds have high ratings. It’s less likely you’d lose your money when investing in them compared to investing in stocks that could decrease in value.
- Fixed income: Since bonds pay regular interest, they can provide investors with a steady income.
- Different options available: As bond ETFs have become more popular, it’s now possible to purchase a variety of bonds for a single price.
Cons of bonds
- Low interest rates: Since bonds are safe investment products, the rate of return is lower than other types of investments.
- May not keep up with inflation: Depending on the current interest rate environment, the return you get from bonds may not beat inflation. In other words, you could lose money by investing in bonds instead of another investment with the potential for more growth.
- Some risk: Lower-quality bonds with a higher yield come with more risk.
Are bonds a good investment right now?
Investing in bonds may be a good idea if you want some fixed income in your portfolio to offset more volatile investments, such as stocks and ETFs.
The length of time before you see yourself needing bond income is also a consideration. Generally speaking, younger investors might not have as many bonds in their portfolio because they have many years of investing ahead of them before they need to access their funds in retirement. However, people who are retired or approaching retirement may want a higher allocation to bonds since they might need regular access to fixed income, and since they have less time to bounce back from any decreases in the value of more volatile investments.