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What are bonds?

Bonds are a long-term investment for passive income. But if you’re seeking liquidity – or big returns – you might want to look elsewhere.

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Kliment Dukovski

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Moira Daniels

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Bonds can be a decent investment option with steady income. But depending on the bonds, your return can be much lower than other investment options.

3 important points to know about bonds

  • Bonds represent loans to government or corporate entities.
  • Bonds are considered a fixed-income investment because the borrower pays a fixed interest rate to lenders.
  • At the end of the maturity date, the borrower must pay back the principal.

What are bonds?

Bonds are an asset class much like stocks, commodities and real estate. But unlike these 3, bonds represent loans made by investors to borrowers. These borrowers are known as bond issuers and are often either government or corporate entities.

Aside from paying back the principal, the bond issuer also pays interest — which can be fixed or variable. This is known as the coupon. Because the bondholder earns interest, bonds are also known as fixed-income securities.

2 types of bonds

Bonds are designed to provide the bond issuer with funds for investments or expenditure. Depending on who issues the bond, there are 2 major types: Corporate and government (including federal, provincial and municipal).

1. Corporate bonds

Companies may resort to traditional loans or bonds to get funds for investments or to cover day-to-day operations. Because bonds often come with lower interest rates and more favorable terms than traditional loans, companies may prefer to choose the bonds route.

But since companies may go bankrupt or fail to pay off their debt, corporate bonds can have a higher risk than Canadian government bonds.

  • Corporate bonds are usually part of a public offering, where a company issues a prospectus informing investors about the offering and allowing them to make a direct investment in the business.
  • Strip bonds (also known as zero-coupon bonds) separate or “strip” apart the interest and principal of a bond and resell each component as a separate investment. On maturity, investors receive a single payment representing the current value of either the principal or the interest.
  • Maple bonds are issued by foreign financial institutions and companies that want to raise money in Canada. Non-accredited investors can only buy maple bonds that are government-guaranteed or issued by certain agencies that aren’t based in any country are are therefore above national regulation.

Tax implications: Interest earned from corporate bonds are subject to both federal and provincial income tax.

2. Government bonds

As the name suggests, government bonds are issued by the federal, provincial or municipal governments and are often referred to as “Treasuries,” T-Bills or sovereign debt. Backed by the government, these bonds are considered one of the safest types of investments.

Depending on the length of the bond’s maturity, government bonds have different names. For example:

  • Government of Canada Real Returns Bonds are backed by the Canadian federal government, and the principal is adjusted for inflation.
  • Provincial bonds are backed by the provincial authority to levy and collect taxes. Interest is paid 2X a year. On maturity, bonds are sold at the current market value.
  • Municipal bonds (also called “munis”) are issued by cities, counties, school districts and sometimes redevelopment agencies often to fund local projects such as schools, sewers and highways.

Tax implications: Interest earned from government bonds are subject to federal and provincial taxes.

How bonds work

When a company or government entity needs money either for investments or day-to-day obligations, it can issue bonds. The bond issuer sets the terms, i.e. the bond’s face value, maturity date and interest rate.

The maturity date is the day when the bond issuer has to pay the principal back to the bondholder. The interest rate is the amount, say 3% annually, paid to the bondholder.

The face value is what the bond issuer will pay for each bond on the maturity date. It’s also the value on which the interest rate is calculated.
Here’s how that would work:

  1. Company X issues a bond with a face value of $1,000, a 2% interest rate and 10 years maturity. Because bonds are negotiable, meaning bond ownership can be transferred to the secondary market, the bond can be resold and bought again at a different price by other investors.
  2. If an investor bought the bond on the market at a discount, say $900, the bond issuer would pay back the face value of $1,000 when the bond reaches maturity, thus the investor earns an additional profit on top of the 2% annual interest rate.
  3. Suppose the same investor bought bonds for $9,000 in the second year after the interest was already paid and held it until the maturity date. The investor would earn $2,716 in interest and in face value difference. That’s a total of around 30% earned in 8 years.

For comparison, the same $9,000 investment in the S&P 500 index with an average annual return of 10% would earn $10,192, or a 114% return.

Bond market price and interest rates can change

Bond interest rates are often determined by creditworthiness and the date of maturity. If the bond issuer has a poor credit rating and the risk of default is high, the interest rate will be high as well. The opposite also applies. Low-risk bonds, such as treasuries, pay low-interest rates.

The bond’s issuer credit quality also affects the market price on the secondary market, meaning quality bonds may cost more than the bond’s face value.

Key terms to know

TermDefinition
Call featureA feature that allows the bond issuer to buy back bonds at a set price in the future. Not all bonds are callable.
CouponA coupon is the annual interest rate paid on the bond’s face value.
Coupon dateThis is the date when the bond issuer pays the interest rate to the bondholder, typically 2X each year.
Credit qualityA measure of a company or government entity to pay its debt.
DefaultA bond default is when the bond issuer fails to pay the interest or the principal back to the bondholder within the specified period.
DiscountA discount is when the bond’s price on the market is lower than its face value.
Face valueThis is the bond’s value paid on the maturity date.
Investment gradeBonds with high ratings and low risk of default are called investment-grade bonds.
IssuerThe company or government entity that issues the bonds.
JunkA term used for high-risk bonds.
Maturity dateThe date when the bond issuer has to repay the principal back to the bondholder.
ParPar is the same as face value.
PremiumThis is when the bond is priced higher than its face value on the secondary markets.
PriceThe present market value of a bond, which may differ from the face value.
PrincipalThe amount of money the bond issuer has to pay to the bondholder on the maturity date.
YieldThis is the return an investor would earn on a bond investment.

Bond ratings

Bonds are assessed by bond rating agencies that take into account the issuer’s financial strength and its ability to pay back the principal and interest on time.

DBRS Morningstar (Dominion Bond Rating Service) is a credit rating service based in Toronto that assesses the credit-worthiness of businesses to determine the risk level of investments. Other popular rating agencies include Moody’s, Standard and Poor’s and Fitch Ratings.

Each of these agencies has its own grades, but in general, bonds with an AAA rating are considered investment grade with low risk. On the other hand, bonds rated CCC are considered junk with a higher risk of default.

Where to find ratings

Finding bond ratings is simple no matter which agency you go with. For example, if you choose Fitch here’s how to find the ratings:

  1. Visit fitchratings.com.
  2. Select the search tab.
  3. Enter the company name or the country you wish to find.
  4. Make sure to use the company full name — eg. Ford Motor Company.
  5. Submit.

Advantages of bonds

Typically offering lower returns than stocks, bonds may not be the first choice for growth investors. But other investors may find the advantages of bonds appealing.

  • Steady income. Bond interest rates provide investors with steady income each year.
  • Preserving capital. On the maturity date, the bond issuer pays back the entire principal to the bondholder. This can serve as a way to preserve capital.
  • Less volatile than stocks. Choosing the right bonds can help you avoid volatility.

Drawbacks of bonds

Despite its advantages, there are some risks to consider.

  • Bond issuers may default. The bond issuer may fail to pay the interest rates and the principal to bondholders.
  • Inflation. Rising inflation may eat up the bond’s interest rates value.
  • Low liquidity. Depending on the bonds, you may find it hard to sell them on the secondary markets.
  • Call risk. Some bonds are callable, meaning the bond issuer can buy them back before they reach maturity.

How to buy bonds

There are 2 main ways to buy bonds: Via a brokerage platform or as an exchange traded fund (ETF). You can buy government bonds directly from the government, but the process is more complex. It’s easier to buy government bonds directly from your broker.

1. Buy bonds from a broker

Accessing the bond market via an online brokerage is one of the simplest and fastest ways to buy bonds. Here’s how:

  1. Find a broker that offers bonds — for example, Interactive Brokers.
  2. Open an account and fund it.
  3. Request access to trade bonds, if required.
  4. Look for the bonds you wish to purchase on the broker’s platform.
  5. Create a Buy order, which can go under the Ask name.

2. Buy bonds as ETFs

ETFs provide a simpler way to invest in bonds. That’s because not every broker lets you buy bonds, but almost every broker allows you to buy ETFs. To buy a bond ETF, you need to:

  1. Have an account with an online broker.
  2. Find the ticker symbol of the bond ETF you want to buy.
  3. Enter the number of shares you want to buy.
  4. Review your order and submit.

Bottom line

As an asset class, bonds are worth considering for investors looking for low-risk, fixed-income options. But this only works for investment-grade bonds. Junk bonds may be good for those who want to make higher returns, but the risk of default is also high.

Frequently asked questions

Disclaimer: This information should not be interpreted as an endorsement of futures, stocks, ETFs, options or any specific provider, service or offering. It should not be relied upon as investment advice or construed as providing recommendations of any kind. Futures, stocks, ETFs and options trading involves substantial risk of loss and therefore are not appropriate for all investors. Trading forex on leverage comes with a higher risk of losing money rapidly. Past performance is not an indication of future results. Consider your own circumstances, and obtain your own advice, before making any trades.

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To make sure you get accurate and helpful information, this guide has been edited by Moira Daniels as part of our fact-checking process.
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Writer

Kliment Dukovski was a personal finance writer at Finder, specializing in investments and cryptocurrency. He's written more than 700 articles to help readers compare the best trading platforms, understand complex investment terms and find the best credit cards for their needs. His expert commentary has been featured in such digital publications as Fox Business, MSN Money and MediaFeed. He’s also well-versed in money transfers, home loans and more — breaking down these topics into simple concepts anyone can understand. In another life, Kliment ghostwrote guides and articles on foreign exchange, stock market trading and cryptocurrencies. See full bio

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Kliment has written 33 Finder guides across topics including:
  • Investing
  • Day trading
  • Stock market technical analysis
  • Personal and business credit cards
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