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.