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Illustration by Melanie Lambrick

Most retail investors traditionally have two main asset classes in their portfolios – stocks and bonds. (A balanced portfolio, by definition, contains both.) But while everyone loves to watch the stock market, and worry about its ups and downs, fewer investors pay as much attention to bonds. Many don’t really understand how they work and the benefits, and risks, of investing in them.

Here’s a primer on bonds and their value in a portfolio, along with some insights from personal finance and investing experts.

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Bonds – which are, essentially, loans from retail or institutional investors to governments or corporations – are an investment security with a fixed term.iStockPhoto / Getty Images

What are bonds?

Bonds are essentially loans from retail or institutional investors to governments or corporations. Companies and national, provincial (or state) and municipal governments issue bonds to raise money to pay for projects and operations, such as financing new public infrastructure (in the case of governments) or to fund capital expenditures, research and development, or even continuing operations.

These investment securities have a fixed term, usually starting at one year and ranging up to 30 years. At the maturity date (the end of the fixed term), the borrower repays the investor the principal amount. Along the way, bonds also make payouts at a set interest rate, called a coupon, usually on a semi-annual basis. A bond’s yield is its rate of return, but there are multiple ways to calculate this. A bond’s current yield factors in the bond’s coupon and current price: For example, if you purchased a bond with a $1,000 face value and a 5-per-cent coupon for $900, its yield at that time would be 5.5 per cent. (The yield will vary as the bond’s price changes.) Its yield to maturity, meanwhile, is a complicated calculation for the bond’s total rate of return once all the interest payments and the face value have been paid.

A bond’s face value is how much it will be worth at its maturity date, which is also the amount the issuer bases its interest calculation on. After its initial issuing, you can buy it on what’s called the secondary market, where its price will fluctuate depending on demand, just like a stock’s. But unlike the stock market, where you can see stock prices increase and decrease in real time, a bond’s secondary market is a decentralized and opaque “over-the-counter” market between bond dealers, such as financial institutions and investment managers.

(At this point, if you are wondering about Canada Savings Bonds, they don’t exist any more. They were offered by the federal government from 1946 to 2017 so it could raise funds for capital projects while giving Canadians a safe investment with a minimum guaranteed interest rate. The government also offered something called Canada Premium Bonds starting in 1998. As of December, 2021, all CSBs and CPBs have reached maturity and stopped earning interest.)

How can I buy bonds?

You can buy bonds during their initial offering and access the secondary market through a broker, or an online discount brokerage.

If you want exposure to bonds without purchasing them outright, you can do that through bond exchange-traded funds, which are traded on the stock market, and via bond mutual funds. These funds tend to invest in a mix of bond types for diversification purposes, and you can purchase funds that invest specifically in short-, medium- or long-term bonds, or a mix of all terms.

Use The Globe and Mail’s 2022 ETF Buyer’s Guide to compare the best Canadian bond funds.

Some bond funds are actively managed, while others passively track the performance of a bond index like the FTSE Canada Universe Bond Index. It’s important to understand that while bond funds of this sort rise or fall in value based on prices in the bond market, these funds never mature like a traditional bond.

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Even as rising rates batter bond prices, they’re a boon for yields, which move inversely with prices.Getty Images/iStockphoto

What’s the relationship between interest rates and bond prices and yields?

The connection between bonds and interest rates is relatively simple: when interest rates rise, bond prices fall, and vice versa. This is because a bond’s price reflects the value it will deliver to the holder in interest payments.

In a rising-rate environment, existing bonds with lower coupons will sell at a bigger discount on the secondary market, because their interest payout is no longer competitive. During times where rates are falling, bonds with higher coupons become much more valuable.

Even as rising rates batter bond prices, they’re a boon for yields, which move inversely with prices.

Many bond managers have started shortening the maturity of their holdings over the past few years in anticipation that record-low interest rates would start to rise, said Melissa Caschera, an investment adviser with BMO Nesbitt Burns in Windsor, Ont. “If we have shorter terms of maturity on bond yields, there’s more opportunity to hold to maturity and get the full value of that bond,” she said. “When you get the fully matured value you can put that cash to work to buy another bond at a higher coupon.”

Investors are quickly returning to a world where it pays to play it conservative, Ms. Caschera said. For so long, bond investors were only getting yields of 1 per cent to 2 per cent, if that. “Now folks with money are finally going to get paid to loan their money out,” she said.

Globe personal finance columnist Rob Carrick noted in June, 2022, that with yields rising sharply, investors with a long-term mindset may have some interesting opportunities in investment-grade corporate bonds.

What are the pros and cons of buying bonds?

There’s a reason why bonds have always been the supporting player in the traditional 60-40 balanced portfolio. Owning them gives you a reliable stream of passive income in the form of regular interest payments. Investors should expect an annualized return of 2.8 per cent from bonds over the next 10 years, according to 2022 guidelines that Canadian financial planners use for projecting long-term investment returns, inflation and more.

What are the benefits of bonds?

They also act as a cushion in your portfolio during times of equity market volatility. “Bonds are going to be fairly stable when the overall stock market is performing poorly; that has been the relationship that’s existed for decades,” said Darryl Brown, investment planner and founder of You&Yours Financial, though he noted the first six months of 2022 have been anomalous, with equities falling at the same time as a series of interest rate hikes have hit bond prices hard. The FTSE Canada Universe Bond Index was down close to 11 per cent for the year through May 18 on a total return basis.

Falling bond prices can be alarming, but Ms. Caschera noted investors’ perceived losses are only on paper rather than in their pocketbook – particularly if they hold the bond to maturity and receive the full face value of their investment. Changes in a bond’s price do not matter if you don’t intend to sell it – the price reflects what investors are willing to pay for a certain income stream, and what the market thinks about the direction of interest rates and the overall economy.

Given their long time horizon to maturity, longer-term bonds carry greater duration risk, which is the sensitivity of the bond price to interest rate changes. For that reason, issuers of these bonds tend to offer higher yields to entice prospective buyers.

What are the biggest bond risks?

In addition to sensitivity to interest rates, bonds carry other risks. All bonds, with the exception of U.S. Treasury or Government of Canada bonds, are exposed to default risk, or the possibility that the issuer could fail to pay back the face value – including provincial and municipal bonds, though their risk of default is considered low. Most bonds also face inflation risk, or the possibility that the purchasing power of interest payments could decrease in an inflationary environment.

Diversification is just as important in a bond portfolio as it is in stocks, said An-Lap Vo-Dignard, senior wealth manager and portfolio manager with Vo-Dignard Provost Family Wealth Management at National Bank Financial in Montreal. Holding bonds of different credit quality and issuer type, region and currency can help mitigate exposure to any one risk.

Mr. Vo-Dignard also encourage diversifying along the yield curve. The yield curve is a term for a graph that plots the yields of bonds of the same credit quality but different maturity dates. In a normal yield curve, longer-term bonds will offer higher yields than shorter-term investments, which indicates economic stability. A steeper yield curve points to expectations for strong economic growth. An inverted yield curve, meanwhile, occurs when short-term interest rates and bond yields are higher than longer-term ones, and is usually indicative of a recession or an impending recession. The U.S. Treasury publishes the most regularly reported yield curve, which compares three-month, two-year, five-year, 10-year and 30-year Treasury Bills.

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There are many types of bonds, including government (federal, provincial and municipal), corporate, high-yield and foreign bonds.Nicolas Hansen/iStockPhoto / Getty Images

What are the different types of bonds?

Bonds are organized by the issuer type. It’s important to keep in mind the issuer’s financial health and creditworthiness: These factors help determine how the bond’s yield, but also the issuer’s risk of defaulting before the end of the bond term.

Government bonds

Government bonds are debt issued by national governments. Those issued by the Government of Canada or the United States Treasury are considered risk-free investments because of their high credit quality – the Canadian government, for example, has a AAA credit rating – which means the issuer is incredibly unlikely to default. Their value to investors is in the guarantee they provide, but because of that safety, government bonds are often the lowest yielding.

Provincial bonds

Provincial bonds are issued by the provincial governments, and are considered a high-quality, secure investment given the provinces’ ability to collect taxes. They offer slightly higher yields than Government of Canada bonds, but can vary depending on the provinces’ credit quality, political risk and other factors. In addition to guaranteeing their own bonds, many provinces guarantee the bonds of provincial agencies.

Municipal bonds

Municipal bonds are issued by municipal governments. While in the United States municipal bonds are tax-exempt, there’s no such provision in Canada. Municipal bonds are generally considered a safe investment because of local governments’ taxation powers, but their credit rating and yields vary. Municipal bond issues can be guaranteed by their home provincial government, but not all will be.

Investment-grade corporate bonds

Investment-grade corporate bonds are those issued by companies with strong financials and credit ratings of at least a BBB by Standard & Poor’s (or equivalent by rating agencies such as Moody’s and Fitch). They’re unlikely to default, but are still considered more risky investments than government bonds.

High-yield bonds

High-yield bonds are also known as junk bonds, and are issued by companies with credit scores below a BBB. While they promise significantly higher yields, it’s important to remember that these come with much higher risk, said Jennifer Tozser, senior wealth adviser and portfolio manager with Tozser Wealth Management at National Bank Financial in Calgary. “The guarantee is only as good as the person issuing it. There’s no implied government guarantee [in a high-yield bond]. Just because it’s a bond doesn’t mean it’s a safe slam-dunk.”

Foreign bonds

Foreign bonds, which are issued by foreign governments or companies, provide a form of portfolio diversification by giving you exposure to other countries and currencies, Ms. Tozser said, though she noted these can be higher-risk investments, depending on the country.

So, should I be investing in bonds?

If you have a balanced fund, a bond mutual fund or bond ETF in your portfolio, you’re already invested in bonds. As Mr. Carrick noted in a 2019 column, bond ETFs are able to acquire bonds at better prices than retail investors could manage on their own, and even after management fees the yields on these ETFs can be “quite competitive.”

While this is the easiest approach to investing in bonds, Mr. Carrick noted it may not be the best. Bond ETFs in particular can fall in price when interest rates rise. Individual bonds bought through a broker or an online brokerage will at least mature and pay you back your principal.

Ms. Tozser noted that major brokers typically have a wider range of bonds than retail investors can access on their own.

The bond market can be challenging for online brokerage account users. However, online brokerages often list the types of bonds available through their platforms and have a more detailed list of all available issuances to allow you to compare and find the term, yield, and risk level that aligns with your investing philosophy. But, Mr. Carrick said, it’s worth keeping in mind that online brokers “use bonds as a profit centre and don’t price them competitively. The higher the price you pay for a bond, the lower the yield.”

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