You buy these bonds for a set amount and for a set period of time. You get regular interest payments while you hold the bond. On the maturity date, you get back the face value of the bond. They’re issued by:
the federal government
government agencies (such as the Farm Credit Corporation)
cities (called municipal bonds)
companies (called corporate bonds).
Learn more about how bonds work.
These bonds have certain features that may improve the return on your investment. But they also have additional risks. They include:
real return bonds.
1. Strip bonds
Strip bonds are created from regular government and corporate bonds. The principal amount and each interest payment are separated and sold as individual investments. You buy a strip bond at a discount. At maturity, you get the face value. The difference between the discounted value and the face value is your interest.
Strip bonds usually offer a higher yield than regular bonds with the same term and credit rating. This is because strip bonds do not make interest payments along the way that investors could reinvest or use as income. For this reason, strip bonds also tend to be affected more by changes in interest rates than regular bonds.
The secondary market (where investors buy bonds from other investors) for strip bonds isn’t as active as the secondary market for other bonds. You may not be able to sell your strip bond when you want to, or you may have to sell it for a lower price than you would like.
If you hold a strip bond outside a registered plan
There are tax disadvantages if you hold a strip bond outside a registered plan, such as an RRSP, a TFSA or a RRIF. Even though you don’t receive interest payments, you still earn interest on strip bonds annually. At tax time each year, you’ll have to calculate how much interest you earned and pay tax on it, even though you won’t get the money until the bond matures.
2. Index bonds
Index bonds keep pace with inflation. If the Consumer Price Index (CPI) goes up, so does the interest rate on your bond.
On the other hand, because index bonds are longer-term bonds, interest rates can affect their value more than other bonds. Learn more about how interest rates affect bonds.
3. Real return bonds
Real return bonds are issued by the Government of Canada and are also designed to keep pace with inflation. Twice a year, you receive interest payments adjusted to the CPI. When a real return bond matures, the amount you get back (the face value) is also adjusted for inflation.
Example – You buy a real return bond with a face value of $1,000. It pays 3% interest. If the CPI goes up 1% after 6 months:
The bond’s face value will go up 1%, from $1,000 to $1,010.
Your interest payment for the first half of the year: $15.15 ($1,010 x half your annual interest rate = $1,010 x 1.5% = $15.15).
If the CPI goes up by 3% by the end of the year:
The bond's face value will go up 3%, from $1,000 to $1,030.
Your interest payment for the second half of the year: $15.45 ($1,030 x half your annual interest rate = $1,030 x 1.5% = $15.45).
Your total interest for the year will be $30.60 ($15.15 + $15.45). A regular bond would have paid $30 interest. With the real return bond, you make an additional 60 cents to cover inflation.
If you hold a real return bond outside a registered plan
There are tax disadvantages if you hold a real return bond outside a registered plan, such as an RRSP, a TFSA or a RRIF. You don’t actually get the extra interest for inflation until the bond matures. But at tax time each year, you’ll have to calculate the extra interest you earned with inflation and pay tax on it.
Content in this section is provided in partnership with Investor Education Fund, a non-profit organization founded and supported by the Ontario Securities Commission that provides unbiased and independent financial tools to help Canadians make better money decisions. To find out more, go to: GetSmarterAboutMoney.ca
Follow us on Twitter: