What are Bonds and Do They Fit Into Your Portfolio?

Bonds might not get as much attention as some other investment options (we’re looking at you, stocks!), but they can play a key role in any balanced, diversified portfolio. 

What are bonds?

In their simplest form, bonds represent a financial obligation to pay specified sums of money on specified dates in the future. Bonds are typically issued by governments and corporations. When an investor buys a bond from an issuer, the issuer promises to repay the principal, which represents the initial amount paid for the bond, plus interest, paid in the form of regular coupon payments.

Bonds are fixed-income securities, which are debt instruments issued by an organization to finance and expand its operations. This provides investors a return in the form of fixed payments and the eventual return of principal at maturity. Other examples of fixed-income securities include treasury bills and Guaranteed Investment Certificates (GICs), all of which represent a loan by the investor to the issuer.

What are the different types of bonds?

As an investor, you can choose from a variety of bonds: federal, provincial and municipal bonds; investment-grade corporate bonds; high yield-corporate bonds; strip bonds and global bonds. 

To assess the creditworthiness of bonds, investors look at bond ratings, which are determined by ratings agencies like Standard & Poor's and Moody's. Expressed as letters, bond ratings range from “AAA" (the highest) to “D” (the lowest). Investment-grade bonds must be rated "BBB-" or “Baa3” or higher. Bonds rated lower than that are considered speculative.

Federal, provincial and municipal governments bonds: Governments issue bonds to pay down deficits or to raise capital for program spending. Generally, maturity terms range from two to 30 years and interest is typically payable on a semi-annual basis. The most highly traded bond issues have terms of five, 10 and 30 years.

• Government of Canada (GOC) bonds feature an ​​AAA rating and are the highest credit quality and most conservative bond available in Canada. They’re guaranteed by the federal government. 

• Provincial bonds vary in credit rating depending on the province's power of taxation and the creditworthiness of the debt. They have higher yields than GOC bonds and are guaranteed by the issuing province.

• Municipal bonds also vary in credit rating depending on the municipality's power of taxation and the creditworthiness of the debt. They may have higher or lower yields than provincial issues of the same quality, depending on specific issues and liquidity. Importantly, they aren’t automatically guaranteed by the provinces in which they operate.

Mutual funds and exchange traded funds (ETFs): are pooled investment vehicles that offer a variety of advantages over portfolios composed of individual fixed-income securities. Such funds are liquid investments and generally allow for easy reinvestment. They can be actively or passively managed by professionals, allowing investors to participate in the market in a variety of ways.

Investment-grade corporate bonds: Corporate bonds are debts issued by companies to raise capital to finance operations and projects. Companies that issue debt are given a rating based on their financial strength, future prospects and past history. Investment-grade bonds must be rated "BBB-" or “Baa3” or higher by credit rating agencies Standard & Poor's or Moody's. Corporate bonds are riskier than government bonds and usually have a higher risk of default. However, the increased risk generally comes with higher returns than “safer” government bonds. Liquidity varies depending on the issuer.

High-yield bonds: Bonds with a credit rating below “BBB-" for S&P or “Baa3” for Moody’s are considered non-investment grade. They’re also known as “junk-grade bonds” because they’re riskier and their ability to repay issued debt is more uncertain. It is important to assess these bonds carefully and to consider the risks.

Strip coupons and residual bonds: Coupons are created from federal, provincial, municipal or corporate bonds, whose two basic components – the semi-annual interest payments (coupons) and the principal amount (the residual) – are separated and sold as individual securities. These instruments are purchased at a discount and mature at par ($100). Generally, the longer the term to maturity, the greater the discount.

Strip coupons and residual bonds pay no interest until maturity and entitle the holder to the security's full-face value at maturity. The interest compounds annually at the yield to maturity at the time of purchase. For example, a Canadian strip coupon maturing in five years with a yield of 6 per cent would be priced at $74.72 and mature at $100. Although no money is paid out until maturity, the interest on the bond accrues each year and must be included as income-on-income tax records annually.

Compared with conventional bonds, strip coupons reduce reinvestment risk over the term of the investment by paying no cash flows until maturity. A strip coupon may offer a higher yield than a bond, but its price may fluctuate more than a bond of similar term and credit quality. 

Strip coupons can offer investors relative safety compared to higher-risk assets (most are government or high-quality corporate-backed), and an attractive yield if held to maturity. Strip coupons remain a popular choice for tax-sheltered accounts such as RRSPs and RRIFs.

When researching bonds, there are a number of things to keep in mind.

What's your time horizon?

Because bonds mean tying up a good amount of money for many years at a time, it's smart to factor in if and when you'll need your original principal. Clarifying your financial goals – as well when you might need the cash – will be key to determining if a bond is right for you. If you choose to sell your bond before maturity, the price you get depends on a host of risk factors, including interest rates and inflation, among others.

Interest rate decisions matter

Bond prices have an inverse relationship with interest rates. So when interest rates rise, bond prices tend to fall, and vice versa. If you hold your bond to maturity, price fluctuations along the way shouldn't be as important to you.

Is a bond right for you?

Bonds are an important component of any balanced, diversified portfolio. To most, they represent a conservative investment vehicle – a secure, low-risk way to generate a steady flow of income. As long as they’re held until maturity, they provide a guaranteed return on your investment, provided the bond issuer remains solvent. Other reasons investors purchase bonds include diversification and potential for capital gains.

A bond might be right for you if you’re focused on adding security to your portfolio, you’re looking for predictable income from your investments, and you want to diversify your investments.

How to find bonds: RBC Direct Investing clients can search bonds by clicking “Research Tools" under the Research menu online, then select Fixed Income. On the Fixed Income Search page, select "bonds" in the product drop-down menu.

Minimum purchase: At RBC Direct Investing, bonds typically require a minimum purchase of $5,000. For a lower minimum, there are also fixed-income mutual funds and ETFs, which are professionally managed and offer monthly income.

Payment frequency: Most bonds follow a semi-annual frequency, meaning you’ll receive scheduled interest payments every six months until the bond matures and you receive your principal back.

Par value: Par value is the face value of a bond, which may be different from what it costs you to purchase it. For example, if the par value of a particular bond is listed at $10,000, but the market price is 99.70/$100, your cost to purchase that bond would be $9,970 (excluding accrued interest). 

Coupon: The interest rate determined by the bond's issuer is called a coupon.

Yield: Yield is the annualized return you can expect to receive over the bond's term.

Bonds are just one of the many fixed-income options available to DIY investors. Learn about GICs, money-market products (including treasury bills, or T-bills) and more in Types of Fixed Income.