Bonds

Bonds are debt securities issued by governments and corporations to raise money. It’s essentially a way for governments and corporations to borrow money directly from investors. Bonds can have both fixed and variable rates of return and some government issued bonds are 100% guaranteed.

How do they work?

When you purchase a bond, you’re agreeing to loan a certain amount of money to a government or corporation for a certain amount of time. In exchange, that government or corporation agrees to pay back 100% of what they borrowed, plus the stated interest.

Some bonds are guaranteed by the government while others can be high risk so the level of risk can vary. Returns on guaranteed bonds are typically lower, while returns on high-risk bonds are typically higher. All bonds carry credit and default risk since they are tied to the issuer's financial viability. If a company (or government) struggles financially, investors are at risk of default on the bond. In other words, the bondholder may lose 100% of the principal invested should the underlying company file bankruptcy. Which type of bond is best for you will depend on how much risk you’re willing to accept in exchange for higher potential returns.

There are lots of different types of bonds to choose from.

Government of Canada bonds: These bonds are issued by the federal government. Government of Canada bonds are considered the highest quality and most secure bonds available.

Provincial bonds: These bonds are issued by provincial governments. Provincial bonds aren’t as secure as Government of Canada Bonds, but often offer higher rates of return.

Municipal bonds: These bonds are issued by municipal governments. Rates offered by municipal governments can sometimes be higher or lower than rates associated with provincial bonds.

Investment-grade corporate bonds: Bonds issued by corporations with a rating of “BBB- “or “Baa3” or higher are considered investment-grade bonds. Corporate bonds are of higher risk than government bonds but tend to offer a higher rate of return.

High-yield bonds: Bonds issued by corporations with a rating below “BBB- “or “Baa3” are called high-yield bonds. These bonds often offer a high rate of return but are much higher risk than investment grade or government-issued bonds. Because they are relatively high-risk, these bonds are sometimes referred to as junk bonds.

Strip coupons and residual bonds: Bonds include two parts: interest payments and the principal (the face value of the bond). When you invest in a typical bond, you own both parts. You’ll receive interest payments at predetermined intervals, and the principal will be returned to you when the bond matures.

Investment firms sometimes separate these two parts – strip coupons and residual bonds – and sell them individually. If you buy a strip coupon, you’ll receive the predetermined interest payments associated with a given bond. If you buy the residual bond, you’ll receive payments equal to the principal amount.

Canada Savings Bond (CSB): CSBs are a type of bond guaranteed by the federal government.

CSBs are purchased through a payroll savings program and provide a guaranteed rate of return. CSBs can’t be traded on the secondary market and only return your principal investment on maturity.

You’ll periodically receive interest payments from compound-interest CSBs but will need to report those payments as income each year.

Unfortunately, CSBs are no longer available for purchase.

Bonds can provide a range of benefits, including: 

• Reliable income payments: The regular interest payments provided by bonds can give investors a steady source of income.
• Low risk: Government-issued bonds and investment-grade bonds are considered low-risk investments.
• Diversification: You can now use bond ETFs to purchase a variety of bonds at a single price.    

While bonds are relatively low risk, no investment is 100% risk free. Risks associated with bonds include:

• Low interest rates: Bonds typically provide relatively low rates of return. Interest rates can be higher for longer-term, or higher risk bonds, but may still be less than other investment products.
• Hard to keep up with inflation: High rates of inflation can reduce the value of any interest payments you earn. For example, if a bond pays a 4% interest, but inflation is 3%, the bond's real rate of return is only 1% when adjusted for inflation.  

What is the main risk of owning bonds?

There’s always some risk that the bond issuer will default on their payments. That risk is relatively low when purchasing government issued and investment-grade corporate bonds, but it’s still a risk.

Can you sell bonds whenever you want?

Yes. You can always sell a bond on the secondary market before it matures. However, it’ll cost you. Bond sales may be subject to certain commissions or “markdowns” charged by brokers to cover the cost of selling the bond on your behalf.

Do you pay taxes on bonds?

Yes. One of the main benefits of bonds is that they can provide investors with a reliable source of income. However, you’ll need to claim that income on your annual income tax return, and any earnings will be taxed at your marginal income tax rate.

Do bonds generate interest income or capital gains?

Bonds can generate interest income and capital gains or losses depending on how interest rates change.

Bonds provide investors with regular interest payments. These payments are treated as income and taxed accordingly in the year that the interest payments are received.

The value of existing bonds tends to go up when interest rates go down, and down when interest rates go up. If interest rates go down, you may be able to sell your bond for more than you paid for it. Any profits gained from reselling bonds on the secondary market will be subject to capital gains. However, if interest rates go up, you may only be able to sell your bond at a discount. If you do, the sale of that bond would constitute a capital loss and make you eligible for certain tax benefits.

Buying bonds can be a relatively safe way to invest, determine your risk profile prior to investing your money. When you buy a bond, you agree to loan your money to a government or corporation for a specific period of time. In exchange, that government or corporation agrees to pay back your principal investment, plus interest. The amount of interest you earn will typically depend on the type and duration of bond you choose to buy.

TD Direct Investing can make it easy to add bonds to your investment portfolio. Open an online account today to help achieve your savings goals.