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A Primer on Bonds – I (The Types of Bonds)





This is a column by regular contributor Clark.

Stocks and bonds (individual or ETF) are two asset classes that form part of many portfolios. The split depends on a person’s risk tolerance but one cannot deny that both are essential components for decent long-term returns with bonds providing some hedge during market downturns through capital preservation and some fixed income generation.

What are bonds?

Bonds are debt instruments issued for varying terms (time-periods) by all levels of government (federal, provincial and municipal bonds) and non-governmental bodies such as corporations (corporate bonds) to raise capital for their endeavors. Typically, a bond is a security where the borrower agrees to repay the principal along with interest (coupon) at a specified date (maturity). Bond income is not given special tax consideration unlike capital gains or dividends and taxed at 100%; so, tax-sheltered accounts maybe better to hold them. Generally, bonds are referred to – based on the date of maturity – as short-term bonds (mature in 1 to 5 years), intermediate-term bonds (in >5 to 10 years) and long-term bonds (in over 10 years).

What are the types of bonds?

Government Bonds. These are products issued by the federal and provincial governments and municipalities. They are considered to be an extremely safe investment, as is the case with bonds issued by the government of any stable country. However, the debts of developing countries hold sizable risk, since they can go bankrupt and default on payments. Usually, municipal bonds are tax-exempt, thereby becoming attractive in a taxable account.

Corporate Bonds. A company can issue bonds similar to stocks. Corporate bonds offer higher yields than government bonds because there is a bigger risk of a company defaulting than a government. The credit rating of a company determines the quality (risk and return) of the bond investment. The higher the credit rating, the lower the investment risks; this also means that the interest rate received by the investor is not as high as in other cases (see below) but still would be greater than government bonds. Some sub-types of corporate bonds are convertible bonds, which the investor can convert into stock and callable (redeemable) bonds, which allow the company to retire them prior to maturity, while paying a premium to holders for doing so.

Some of the other variations… (note that there are more than the three given below)

Real Return Bonds. These are Government of Canada bonds that pay a rate of return adjusted for inflation. Unlike regular bonds, these bonds help the investor maintain their purchasing power irrespective of the inflation rate in future years. They pay interest semi-annually based on an inflation-adjusted principal. E.g. A $100 bond with 3% interest rate and present inflation rate of 2% will pay $2.50 [$100*(3%+2%) / 2] after 6 months. If the inflation rate increases to 3% by the end of the year, the interest paid will be $3.00 [$100*(3%+3%) / 2] for the second 6-month period. However, since the inflation adjustments are treated as taxable income despite the investor not selling the bond or it reaching maturity, they are suitable in an RRSP or TFSA.

Junk Bonds. These bonds are issued by companies that do not have an investment-grade rating. These companies need the money but banks may not finance their efforts due to a poor credit rating (corporate bonds could be issued on top of bank loans and not in their absence) and so, they turn to bonds. The risk of default is higher than for corporate bonds but they offset the additional risk borne by investors with a better payout (yield).

Zero Coupon Bonds. This is a type of bond that makes no coupon (interest) payments. Instead, the bond is issued at a substantial discount rate to par value i.e., a zero coupon bond of $100 par value maturing in 10 years could be trading at $70 today, thereby providing a 30% discount (for a bond that will be worth $100 in 10 years’ time). It should be noted that since interest (the difference between par value and today’s rate) is compounded and considered as earned, holders of zero coupon bonds have to pay taxes each year on the accrued interest i.e., they have to pay tax before getting the money.

To summarize, based on increasing degree of risk: Government Bonds < Corporate Bonds < Junk Bonds. Real Return Bonds help an investor negate the effects of inflation by indexing their payments to inflation.

Do you have a fixed income portion of your portfolio?  If so, what type of bonds do you invest in?

Stay tuned, Part 2 will deal with interest rate risk, suitability for portfolios and ways to hold bonds.

About the Author: Clark is a twenty-something Saskatchewan resident employed in the manufacturing sector. He repaid around $20,000 in student loans and has been working to build his investment portfolio as a DIY investor (not trader) while nurturing plans to retire early. He loves reading (and using the lessons learned) about personal finance, technology and minimalism.





21 Comments, Comment or Ping

  1. I like reading about bonds. :)

    A couple of things:

    1) Municipal bonds (do they exist in Canada?) are not tax-exempt. That’s only true in the US.

    2) For real return bonds, you mention “inflation-adjusted principal”, and yet your interest payment calculation includes the inflation adjustment.

    In fact the principal amount is adjusted upwards for the inflation rate, but you don’t get any interest payment – you just get the extra principal when the bond matures.

    This makes rr bonds very undesirable for taxable accounts because the inflation-adjusted amount is taxable every year but you don’t get that money until the end.

    Here is an article which explains real return bonds indepth:

    http://www.bylo.org/rrbs.html

  2. 2. Elbyron

    For a RRSP or TFSA, are real return bonds better to hold than regular govt bonds because you’re guaranteed to beat inflation? Or do RR bonds generally pay a lower overall rate?

  3. 3. Charles in Vancouver

    “Usually, municipal bonds are tax-exempt thereby becoming attractive in a taxable account.”

    If the author is Canadian, why in the world is he saying this??

  4. 4. Clark

    Thanks for the comments.

    @Mike: Municipal bonds exist in Canada but they are few and are mainly for capital investments than operational purposes. Even those few bonds are guaranteed by the provinces and hence, essentially provincial bonds. You are right that municipal bonds are not tax-free in Canada. Sometime back, there was a bill in the Senate proposing tax-free municipal bonds but I do not know about the progress on that. Since you like reading about bonds, here’s a related paper (just 2.5 pages) on municipal bonds :)

    http://www.suma.org/…/Discussion%20Paper%20-%20Municipal%20Bonds.pdf

    I accept that I got it wrong wrt the RRBs. For my example, after 6 months, the inflation-adjusted principal would be $102 and the interest would be $1.53. For the second 6-month period, the principal would be $103 and the interest would be $1.55. Thanks for spotting it! But, you should note that interest is paid out in addition to the inflation-adjusted principal at maturity.

  5. 5. Clark

    @Mike: Here’s the correct URL for the paper…
    http://www.suma.org/cmsupload/fckeditor/Discussion_Papers/Discussion Paper – Municipal Bonds.pdf

  6. Thanks Clark. I used the wrong word in my comment.

    you don’t get any interest payment

    should have been

    you don’t get any inflation adjustment payment

    You’re absolutely right that the normal interest payments are paid out on schedule.

  7. 7. Miltiadis

    @Clark Nice summary, looking forward to part 2!! Maybe we’ll get advice on how to analyze bonds? :D

  8. 8. Jenna

    Don’t currently invest in bonds – but I might look into it more after this post. Thanks for sharing!

  9. 9. Clark

    @Miltiadis: If I share my secrets to analyzing bonds, then FrugalTrader will have to put a paywall for that special post! Jokes apart, I do not know what parameters to look for when buying individual bonds. I hold a bond index fund but haven’t bought bonds in any form for a while – strictly stock bargains for now!

  10. 10. Miltiadis

    @Clark

    Ha ha! I agree with the bond fund! There’s just no fun in analyzing bonds, but you never know… I have a bond index as well. Bonds don’t have the same upside as stocks! :D

    Most of my portfolio is indexed but i would like to start researching individual securities, just for fun and maybe some profit!

  11. 11. mortgage broker

    Yeah,I do not know what parameters to look for when buying individual bonds. I hold a bond index fund but haven’t bought bonds in any form for a while – strictly stock bargains for now!!!

  12. Clark
    Hope your bond series gets to explaining the inverse relationship between bond prices and yields — many people don’t understand that

  13. 13. JFG

    Small thing

    Holders of Government of Canada bonds receive a promise of regular interest payments and repayment of principal at maturity, but no rights to a claim on the underlying. Canada Savings Bonds are technically debentures, but they represent the highest domestic credit quality and are classified as bonds for investment purposes.

    I have started to sell my bond ladder (inside my RRSP) and buying ETF’s. Corporate for now, due to higher possible return and I’m still at least 15 years from retirement.

  14. 14. Clark

    @ Larry MacDonald: The second (and concluding) part includes that issue. I hope I did a decent job at addressing it.

    @ JFG: Thanks for the insight. I’ve been looking at corporate bond ETFs but do you think there is enough upside to them when compared to a short-term bond ETF like XSB that offers better diversification?

  15. 15. JFG

    Apples and Oranges.

    One is shorter term and the other for longer term. Depends what you are looking for.

    I love ladders. The Claymore Corporate bond ladder offers what I’m looking for. Potential for growth, regular income and is for the long term (well for me anyways).

    Short term bonds offer more flexibility. Their upswings and downswings are USUALLY not as severe.

    Just to give you an idea. At the stage in my life, most of my retirement funds are in Growth. I do have a GIC and a bond ladder (I started selling my bond ladder and purchasing the Claymore Corporate Bond Ladder ETF). I only reinvest the capital. The interest, I put in a short term bond MF. When something like ’08 came along, I had enough cash to purchase a stock that I was looking at. It was trading at $20/share, but dipped to $13/share. Sell high, buy low. I used short term bond because it pays way more then a Money Market, moves slowly and offers flexibility.

    Both are part of a portfolio, when you know what to do.

  16. 16. document verification

    nicely written Clark, you have given a very good over view of bond system, which I studied during my business administration course

  17. I am the most interested in junk bonds. They have the most risk, but think if selective can provide a really nice return. Did you have any recommendations are the best way to analyze junk bonds? I am years from retirement though and can take a bit more risk. Thanks. Steve

  18. 18. Jeremy

    What would be the ideal allocation within bonds? Short? intermediate? corporate? government? TIPS? Real return?

  19. 19. Clark

    @MakingAMillionDollars: Unfortunately, I do not have any insight about junk bond analysis.

    @Jeremy: I’d say that there is no “one size fits all” bond allocation. Government vs corporate involve defaults (corporate) in addition to interest rate risk. Short-term bonds mitigate the impact of rate fluctuations (compared to longer term bonds) but do not hedge completely. TIPS and Real Return Bonds (RRBs) are the same product with different names: US = TIPS; Canada = RRBs. I think the allocation depends on your risk tolerance, which should be based on attributes such as age, financial position (ability to face principal loss), investment knowledge, investor type (conservative/enterprising; it may take an enterprising one to buy junk bonds), etc.

  20. 20. Jeremy

    But I see lots of model portfolios with a clear recommended asset allocation examples for equity but the fixed income component is not really diversified

  21. 21. Cheap Insurance Guru

    thanks, this is a good intro to the topic. I would love to read more about corporate bonds – maybe you could cover that in another post?
    Keep up the good work!

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