What are bonds and what types are there?

Disclaimer: I am not a financial advisor. You are trading and investing at your own risk and should consult a financial advisor for any investment decisions. Do your own due diligence when considering investing, and information about “What are Bonds?” is for education/informational purposes only. This article serves as educational and entertaining content, not investing advice.

A short while ago, I sprung upon the idea of writing about bonds, more specifically, writing and learning about if bonds are still a good investment.

The ambition was derived upon me after reading The Intelligent Investor and watching a video on YouTube about this topic I’m writing about (unfortunately, I don’t remember the video to give credit).

So today, I want to attempt to go more in-depth on this topic and discover if bonds are really worth investing in or whether we should focus specifically on index funds or ETFs, as every big personal finance YouTuber is telling us.

I’ll, of course, cover a few of the basics of bonds to anyone new to the investment itself, and hopefully, we all can learn something new today.

What are bonds and how do bonds work?

I was introduced to bonds a very long time ago, or so it feels. I was introduced by learning slightly what they actually were and how to calculate them.

But bonds themselves are a type of debt issued from the government, banks, corporations, and other authorities.

They issue these debts for people in the public to purchase. Their reasoning is that it provides the issuer (the one issuing the bond) with some short-term cash flow to help with their operations, investments, or whatever they need it for.

The advantage for the buyer is that they receive a set of interest payments over the length of the bond, known as maturity. Bonds state how long they will last, which could be a year to even 10 years or more. They typically don’t last forever.

What happens when a bond defaults?

You may have heard the word default before, but what happens is when a bond issuer defaults, they are no longer to make their payments of interest or the face value. When this occurs, you can lose all of your investment, unless there are some regulatory laws put in place.

As you will come to know, some bonds are riskier than others because there is an increased chance they will default than any more secure bonds.

Compositions of the bond:

I’ll briefly discuss some of the terms associated with bonds:

  • Face value: The face value is the price that the bond will reach at the end of its maturity. It usually ends something like $1,000 or $10,000, but it depends on the bond.
  • Interest rate/coupon rate: the rate at which interest payments will be calculated and later paid out as interest payments
  • Maturity: length of the bond/how long the bond will last until it ends
  • Maturity date: the date the bond matures
  • Market value/issue value: the price the seller lists their bond at/the price the buyer purchase the bond at
  • Discount: the market value is at a lower price than the face value of the bond
  • Premium: the market value is at a higher price than the face value of the bond
  • Par value: the market value is the same price as the face value

Premiums and Discounts:

Photo by Justin Lim on Unsplash

If you are new to the concept of bonds, you might think it’s a little ludicrous to pay a market price higher than the face value of the bond.

Yet, in doing so, there’s an advantage. The bond pays a higher amount of interest than a discount or par value bond. In fact, premium bonds often have a higher prevailing interest rate than the market rate. Meaning they offer an interest rate higher than what you can find to similar bonds in the market.

With that said, purchasing a bond at a discount value offer lower interest rates because the prevailing interest rate is lower than the market interest rate.

The link above provided a good example; imagine that Serge purchased a 10-year bond 5 years ago that had an interest rate of 7%. 5 years later, or current day, he decides to sell the bond because he’s not locked into the 10 years.

Instead of valuing the bond as a 10-year bond rather, it’s valued as a 5-year bond because that’s the remaining years until it matures.

In the market, we will assume that the market interest rate for 5-year bonds is 5%. Serge’s bond will most likely trade at a premium because of the higher interest rate.

Par Value:

In some cases, bonds may be issued at just their par value, meaning that they are being offered at $1,000 per bond while maturing for the same amount.

This also means that you would only be earning interest as a payment.

And it’s also not to say that the market value wouldn’t fluctuate from $1,000. It could fluctuate and change to a premium or a discount depending on the market’s interest rates, as we have come to know.

Bond Ratings:

I’ve heard of bond ratings and have vaguely understood them, but I wanted to learn a little more about them as maybe you do as well.

According to this piece written by BMO, the bond rating/investment grade is a particular grade given to a bond that reflects its credit quality. The evaluation indicates the bond issuer’s financial strength or ability to pay a bond’s principal and interest on time.

If you haven’t seen bond ratings before, they are all expressed in letters. Here are some of the ratings vaguely described by me, but you can find an avid description of each using the link above:

Rating Definition:Rating:
High quality and grade. The issuer’s capacity to meet the financial commitment on bonds are very strongAAA – AA
Upper to overall medium quality and grade. The issuer’s capacity to meet the financial commitment on bonds is strong or adequate, depending on economic conditions.A – BBB
Speculative. Uncertainties and adverse business or economic conditions could lead the issuer to not pay out their commitments.BB – B
Low grade. Default is possible, meaning that there may be issues that will cause the issuer to default bonds as they cannot pay.CCC – CCC
It may be in defaultC
In default. A bankruptcy petition has been filed, or similar action has been taken. Payments on obligations are not made on the due date.D

Risk is much higher if one decides to purchase a bond with a meager rating, and it seems that there is a big chance that the bond will default. Maybe it’s more than just “considerable” and that it’s “likely.”

Either way, the rating seems to be essential for investors to understand if the issuer will be able to meet their commitments. Just as it’s crucial to view the interest rates of the market and the ones being issued on bonds.

Speaking of which, there is an inverse relationship between bond ratings and interest rates. The higher the grade a bond is, the lower the interest they will pay. The lower the grade, the higher the interest it will produce.

The higher amount of interest is to help counteract the risk that is associated with the lower gradings of bonds. The interest may seem tempting, but the feeling of losing the investment will be a more strong emotion if defaulted.

Callable bonds:

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Callable bonds are fascinating, and admittedly, I heard about them before but didn’t understand them.

They are that anytime a bond is callable, the issuer can redeem them. That means that they can pay the face value to the holder and maybe a little more.

The additional amount paid could be a payment worth of interest or just a simple premium.

There’s a reason the issuer would do this, however, because of the interest rate.

The interest rate on the bond may be higher than the current market interest rate after some time has passed since the bond had been issued.

An issuer may think, “Why should we pay so much interest?” And decide to call the bond, following to proceed and issue new bonds reflecting the current interest rate.

Investopedia offered a great example which I will provide below.

“Let’s look at an example to see how a call provision can cause a loss. Say you are considering a 20-year bond, with a $1,000 face value, which was issued seven years ago and has a 10% coupon rate with a call provision in the tenth year. At the same time, because of dropping interest rates, a bond of similar quality that is just coming on the market may pay only 5% a year. You decide to buy the higher-yielding bond at a $1,200 purchase price (the premium is a result of the higher yield). This results in an 8.33% annual yield ($100/$1,200).

Suppose that three years go by, and you’re happily collecting the higher interest rate. Then, the borrower decides to retire the bond. If the call premium is one year’s interest, 10%, you’ll get a check for the bond’s face amount ($1,000) plus the premium ($100). In relation to the purchase price of $1,200, you will have lost $100 in the transaction of buying and selling. Plus, once the bond is called, your loss is locked in.”

The issuer may also just want to retire the bond early. That’s possible as well.

In any case, whether a bond is callable or not should be disclosed in its description.

Different types of bonds:

Zero-coupon bond:

A zero-coupon bond is a bond that doesn’t pay out any interest at all. Instead, the only profit earned is when it matures and pays out the face value.

As you may have guessed, these bonds make a trade at a discount, either when-issued or repackaged and stripped of its coupon/interest rate.

With that in mind, these bonds can fluctuate more in price, making sense since investors will receive the full payment at its maturity.

This certainly doesn’t seem ideal for someone who would often want a fixed income streaming into their portfolio.

Whether these payouts are more than a typical bond is difficult to estimate. But it seems that it would be essential to evaluate what the market reflecting currently, as the interest rate will be set for the maturity of the common bond, and you can compare it with how much you’ll earn from a zero-coupon bond when it matures.

Tax-free bonds:

There seem to be no tax-free bonds in Canada as there are in the United States.

Through a bit of research, it seems that I cannot find anything related to it other than municipal bonds.

These municipal bonds might be offered through the government in provinces or territories across the nation.

While I have read they may have a better yield than the government of Canada bonds, they seem to not be tax-free. I understand this article was written in 2006 when it described this, but I can’t see anything saying it has changed.

Speaking of municipal bonds, from what I’ve read, they typically offer a higher yield than bonds issued by the Federal government but aren’t guaranteed and may have a minimum order size of $5,000. Additionally, their credit rating isn’t as high as saying the government of Canada bonds would be.

Something might be worth looking into, though. Let me know if you’re interested in analysis.

Canadian savings bonds:

It seems back in 2017 that the government of Canada decided to discontinue their sale of the Canada Savings Bonds program.

From the official website, it was due to a decline in sales and access to alternative investment that it would no longer be a part of the government’s debt management strategy.

All bonds have matured at the end of 2021, and the remaining interest has been paid out.

Junk/High Yield Bonds:

Junk bonds are essentially bonds that pay higher interest than you will find in other bonds across the market but have a poorer credit rating. They, in fact, can be so poor that they hinge on the risk of default.

Much riskier bonds will trade at discounts, while sound companies that offer bonds will sell at premiums or at par.

The higher income stream they could provide is mightly tempting for one’s portfolio. Let’s not deny that. But as made mentioned, there’s more risk that these things will default, and one will lose their position in the portfolio or even miss an interest payment.

The most critical factor for the success of a junk bond would likely be the company issuing itself. People will only get paid if they are strong financially and can meet the payments. Otherwise, if they are declining in business or not being managed well, it may not be a surprise when they have to default.

Inflation-Protected bonds:

Apparently, a popular bond investment is inflation-linked bonds (ILBs).

Since inflation does eat at the returns from investors, this is an investment vehicle that adjusts for inflation to reflect the same amount of return one will receive no matter if inflation rises or decreases.

Here’s an example from Qtrade:

“Say, for instance, you decided to purchase an ILB issued at $1,000 with a fixed annual coupon of 5 per cent. If the inflation rate remains unchanged, the bond will pay you interest of $50 every year.

However, if the CPI rises 2 per cent, the principal will then be adjusted to $1,020, and the annual coupon payment you receive will increase to $51. When the bond matures, its principal will be adjusted for inflation.”

But another good question to ask is what happens to these bonds where inflation decreases?

Well, given how long it may occur, the inflation-adjusted principal could fall below the par value for the bond, and the interest payment would therefore be lower, as it would be based on the deflation-adjusted amount.

These inflation-protected bonds are called Real Return Bonds (RRBs) in Canada. However, they don’t offer any deflation floors, so if there is deflation, it could lose value or end in a capital loss at maturity.

Additionally, they have long maturities that could extend over 20 years, which means that the bond can become more volatile when the interest rates begin to fluctuate, and in 20 years, who knows what the markets will look like.

But it should be stated that the inflation compensation and interest payments are taxed in the year they occur.

Corporate Bonds:

Corporate bonds are a type of debt that is issued by certain companies. What companies might issue some bonds? Well, here’s a shortlist of some Canadian companies that do:

  • Bell Canada
  • TELUS Communications
  • Enbridge Inc.
  • John Deere Canada Funding Inc.
  • Honda Canada Finance Inc.

You can find a complete list through the Bank of Canada’s website by clicking here.

But what is the difference between these types of bonds and government bonds?

Well, with corporate bonds, there is always a risk of default as the payments and principal to be returned are based on whether the company is in good financial health. In which case, they certainly may not be.

As they are riskier, they will likely pay higher interest rates to incentivize investors to invest in their bonds.

Mortgage-Backed Bonds:

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These may also be known as mortgage-backed securities. Let me provide an example of how they work.

You live in a small town, and recently 5 people have purchased homes within your area. All five of these people put a downpayment on their houses but then decided to get a mortgage from the bank to pay for the rest.

You, as an investor, begin to look into bonds, and while you have searched for a while, you see that your local bank is offering a mortgage-backed bond. Your characteristics are intriguing, and you decide to purchase a bond and hold it until maturity.

This mortgage-backed bond is from the mortgages of the five new homeowners. Essentially, it means that you are lending money to these individuals to purchase their homes (in a way).

The bank pools mortgage together and will offer them as a bond while generating your interest payments and eventually your investment when it matures. This all happens while the homeowners are making payments; therefore, banks generate revenues to the bank or other areas.

If the homebuyer defaults, the bank will lose nothing as a result. I believe this is because the bank could then, in turn, default these bonds as a result of the homebuyer not being able to make any payments.

However, governments require that the security has received one of the top two ratings issued by a credit rating agency to help avoid what had happened in 2008.

Therefore, it does help keep investors’ worries a little more at ease for these types of bonds.

Foreign Bonds:

As the name implies, a foreign bond is a bond issued by foreign countries.

The benefits? One of the main benefits is diversifying and broadening their portfolio to different markets without any added exchange rate exposure.

However, it does not come without its disadvantages, which is similar to most bonds. You have the interest rate risks, where if the interest rate throughout the market increases, then the bond’s market value will further decrease.

There is also a currency risk due to the exchange rate differences between the foreign country’s currency and your country’s currency. It is no different necessarily than investing in stock from foreign exchange in this regard and can cut into your profits.

The political risk would be an essential factor. It would be an excellent idea to consider if the bond is stable, the government is stable, their laws and regulations around bonds, and even the government’s economy. If the country collapses, well, the bond may too.

Advantages and Disadvantages of Bonds:

While at the time of this writing, I have come to know some of these characteristics of bonds, I have continued to do some research and find what other advantages and disadvantages of bonds are for all of us to know. Here’s what I found:

Advantages of Investing in Bonds:Disadvantages of Investing in Bonds:
Fixed income for a portfolioCan lose money due to fluctuating interest rates
Inflation protected securities help protect one’s portfolioDepending on the type of bond, it could suffer from high volatility
Don’t need to hold until maturity, can be sold at anytimeBond calls can cause investors to lose out on high-interest payments
Government of Canada bonds never default, making the bond a risk-free investmentForeign bonds offer political and exchange rate risk
Most bonds, especially government bonds, have low volatilityBonds can default, leaving holders with little to no money
Stable investment for those who want to retire early and live off a fixed incomeAllocating a lot of a portfolio to bonds could be a very conservative approach and lose out on higher returning investments.
Credit ratings give investors a sound idea of whether a bond will default and continue to make payments.Possibly need a more considerable sum of investment to start investing in bonds.
DiversificationInterest rate changes could make bonds trade at a discount and lower their market value

Here is a list of the sources I found with some advantages and disadvantages of bonds used in this list:

Advantages and Disadvantages of Investing in Bonds | FlexJobs

Advantages and Disadvantages of Bonds (zacks.com)

The Pros & Cons of Investing in Bonds (fifthperson.com)

Concluding Remarks:

Whether these have a spot in your portfolio is up to you. However, bonds seem to have a significant value in what they can provide to investors.

While stocks or other equities can fluctuate and have returns eaten up by inflation, bonds can offer safety to both of these risks.

I think bonds are still worthy of being looked at rather than just going all out on stocks or index funds, which will be discussed in the following article.

Do you invest in bonds? Let me know by reaching out on social media.