The ABCs of bonds

08 September 2022 by National Bank Direct Brokerage
Two hands protect a piggy bank on a table

When it comes to investing, whether you’re self-directed or you use the services of an advisor, the importance of diversification cannot be understated. Fixed income securities have traditionally been part of that solution as well as providing stability within the portfolio, especially during periods of volatility.

 

Contribute to your RRSP or TFSA without leaving your home

Picto inspiration
Did you know that the global fixed income market is larger than the global equity market capitalization¹?  And yet most investors aren’t familiar with this asset class.

What are fixed income securities (bonds)?

A fixed income security is an investment that provides a return in the form of fixed periodic interest payments. They are usually semi-annually and at the end of the term the principal amount is returned. Bonds are the most common type of fixed income security, and many investors will use one term or the other.

The bond is a loan made from an investor to a borrower, which can be a government or a corporation who raises money to finance projects and fund operations.  

What are the different types of bonds?

They fall under two main categories: government or corporate fixed income securities. 

Government Bonds

All levels of government (Federal, Provincial, Municipal) can issue bonds. Government bonds are generally considered safer versus corporate bonds, because of their ability to raise revenues via taxes to meet their obligations. The highest quality being those issued from the Federal government.

Within this category there are also fixed income securities issued by foreign countries (U.S., European, Asian, Emerging Markets, etc.) with similar maturity terms but with varying levels of risk.

Corporate Bonds

Corporate bonds are debt securities that have been issued by private and public corporations. In many cases, the shares of companies that can be bought and sold also can have fixed income securities that can be purchased. There are two main types of corporate bonds:

- Investment-Grade Corporate Bonds are fixed income securities that have been issued by corporations that bond rating agencies consider as very likely to be paid back at maturity, with interest. Within this category there are differing grades but in general, these are established companies that generate profits and have a capacity for repaying their debts.

- High-Yield Corporate Bonds which are also known as Junk Bonds. These fixed income securities have a lower credit rating, implying a higher risk than investment-grade bonds. These bonds will offer a higher interest rate to the investor because of the higher risk. Issuers of high-yield bonds tend to be start-ups, capital-intensive firms and already have large amounts of debt outstanding or companies. 

The terms to maturity for government and corporate bonds can vary between one to ten years, but longer-term bonds can also be issued. 

Good to know!

Bond maturities and their credit ratings the following holds true:

  • Investors will demand higher yields on longer-term bonds.
  • Investors will demand higher yields on bonds with lower credit ratings versus those with higher ratings.

Key terms to know about bonds

Before explaining how bonds work, let’s begin with a list of bond terms to know. These are the most common terms used and will help you better understand the characteristics of fixed income securities.

- Face value (par value): Bonds are issued in units of $1,000 and at maturity the investor will receive the face value of the bond. The interest payment calculation is also based on the face value of $1,000. Please note that at issuance and during the term, the bond price will fluctuate and can be at a premium (higher price) or discount to its face value.

- Coupon rate: Is the rate of interest the bond will pay on the face value of the bond, expressed as a percentage. In most cases, interest is paid semi-annually on fixed income securities. You will see more explanation on the coupon rate in the “How interest rates affect bonds” section below.  

- Yield: To calculate the yield of a fixed income security, take the coupon rate of the bond and divide it by the current market price of the bond. 

Coupon rate / bond current market price = yield

Since fixed income securities prices can be at a premium or at a discount the investor would want to know what the actual yield is when purchasing.

  • When the bond trades at a premium the yield is lower than the coupon rate.
  • When the bond trades at a discount the yield is higher than the coupon rate.

- Maturity date: Is the ending date of the fixed income security and the bond holder will receive one last interest payment and the face value of the bond. Please note certain bonds, usually corporate have an extension feature where the bond has an initial maturity that can be extended by the issuer. These bonds will appear with two maturity dates.

How do bonds work? 

Suppose an investor wishes to purchase a municipal bond and has $10,000 available. After reviewing the inventory, a new issue municipal bond is available with a coupon rate of 4.00% maturing in 5 years and the price of the bond is at fair value. In this case the coupon rate and yield will be the same.  

The investor will receive a total of $400 annually in interest payments, paid semi-annually ($200) for a period of 5 years and at maturity will also receive the principal amount which was invested $10,000. The amount will appear the following business day in the cash holdings of the brokerage account. 

How interest rates affect bonds

One of the basic rules when investing in fixed income securities is that, in a normal yield curve environment, the yield will increase as the maturity of the bond increases. Investors demand higher interest rates to lend their money out for longer terms.

There is also an inverse relationship between bond values and increasing or decreasing interest rates. Another factor that will influence the bond value is the coupon rate and maturity date of the bond. All else being equal the following will apply:

  • Increasing interest rates can causes bond values to decrease. 
  • When interest rates are increasing bonds that have shorter maturities and\or higher coupon rates will be less affected (vice versa)
  • Decreasing interest rates can cause bond values to increase. 
  • When interest rates are decreasing bonds with longer maturities and\or lower coupon rates can increase more (vice versa).
Interest rate Bond price ($) Low coupon bond High coupon bond Shorter maturity Longer maturity
Increasing Down Decreases more ($) Decreases less ($) Decreases less ($) Decreases more ($)
Decreasing Up Increases more ($) Increases less ($) Increases less ($) Increases more ($)

These changes will result in the price of existing bonds to fluctuate which can result in the bond price to trade at a premium (higher than the face value) or at a discount (lower than the face value).

How to buy fixed income securities at NBDB?

Pros & Cons of bonds

Pros Cons
Bonds offer diversification from stock market risk, as bonds are generally less risky than stocks.
Fixed income securities typically provide a lower return than equities
over the long term.
The coupon rate on the bond offers a steady predictable income for the investor.
Inflation risk is an issue because the coupon rate is fixed on most bonds but if inflation is higher than that rate the investor loses purchasing power.
Government bonds offer a lower risk and capital preservation versus equities. Credit risk is the risk of default from the issuer (corporate bonds) and liquidity risk (having to sell the bond before maturity and not being able to get a favorable price).

How can I add bonds to my portfolio? 

Direct brokerage firms offer bonds to their clientele via their online platform, usually with a minimum purchase amount. Unlike stocks there is no centralized market for the buying and selling of bonds, each broker will manage their own inventory. 

Another option is using mutual funds or ETFs that invest in fixed income securities which hold numerous holdings and provide diversification. 

In the ETF space, investors can select from passive or actively managed ETFs as well as ETFs that only hold governmental or corporate bonds or a mixed version.

View our tutorial on the ETF Centre.

Bonds can help you diversify your investments

Depending on your investment objectives and income needs, adding fixed income securities can potentially help in smoothing out the ups and downs of your portfolio and help your returns. National Bank Direct Brokerage clients have access to individual bonds and can easily search through the inventory to find the ones that best suit their needs. Or select amongst the numerous ETFs and mutual funds available using our tools to help you refine your search.

¹ Capital Markets Fact Book, 2022 

Key Takeaways:

- Bonds or fixed income securities can allow investor to apply diversification and risk management strategies to their investments. 

- The bond is a loan made from an investor to a borrower, which can be a government or a corporation who raise money to finance projects and fund operations.  

- The terms fixed income securities and bonds fall into two categories: government, and corporate bonds.

- Corporate bonds will pay a higher yield versus government bonds because of the increased risk of default.

- Investors demand higher interest rates to lend their money out for longer terms, so longer maturity may pay more.

- Words to remember

  • Face value (par value)
  • Coupon rate: Is the rate of interest the bond will pay on the face value of the bond, expressed as a percentage. 
  • Yield = coupon rate / bond current market price = yield
  • Maturity date: Is the ending date of the fixed income security.

- Pros of bonds

  • Bonds are generally less risky than stocks.
  • The coupon rate can predict the investor’s return on bonds.
  • Government bonds offer a lower risk and capital preservation versus equities.

- Cons of bonds

  • Bonds can provide a lower return than equities over the long term.
  • Inflation risk is an issue because the coupon rate is fixed on most bonds but if inflation is higher than that rate the investor loses purchasing power.
  • Selling the bond before maturity can mean not being able to get a favorable price.

- Investors with smaller portfolios or those looking for additional diversification can select ETF and mutual fund bond offerings.

- Learn how to buy fixed income securities at NBDB 

Legal disclaimer

The articles and information on this website are protected by the copyright laws in effect in Canada or other countries, as applicable. The copyrights on the articles and information may belong to the National Bank of Canada, its subsidiaries or other persons. Any reproduction, redistribution, communication by telecommunication, including indirectly via a hyperlink, or any other use thereof that is not explicitly authorized, of all or part of these articles and information, is prohibited without the prior written consent of the copyright owner.

The content of this Web site is provided for general information purposes and should not be interpreted, considered or used as if it were financial, legal, fiscal, or other advice in any way. In addition, the information presented on this Web site, whether financial, fiscal or regulatory, may not be valid outside the province of Quebec.

This article is provided by National Bank Direct Brokerage (NBDB) for information purposes only. It creates no legal or contractual obligation for NBDB and the details of this service offering and the conditions herein are subject to change.

The hyperlinks in this article may redirect to external websites not administered by NBDB. NBDB cannot be held liable for the content of external websites.

Views expressed in this article are those of the person being interviewed. They do not necessarily reflect the opinions of NBDB.

Categories

Categories

 

Contribute to your RRSP or TFSA without leaving your home