Bond Basics

000 and they pay you a fixed rate of interest for a specified period of time. Governments (federal. .What is a bond? You've just loaned your neighbour $1. and then he’ll give you back your money.000 so that he can renovate his home. He's promised to pay you 6% interest each year for the next 5 years.  A bond works much the same way – you give a company $1. provincial and municipal) and corporations use bonds to raise the capital they need to expand. after which they return your principal.

00 $60. Let's say that you have a $1.00 Year 4 (6% interest on $1.00 Year 2 (6% interest on $1.00 Year 1 (6% interest on $1.00 Total principal and Year 5 (6% interest (at maturity interest on $1.300.Making money: nterest and capital gains There are two ways to make money from a bond – either by earning interest or capital gains.000 bond that pays 6% interest for five years.000) $60. Principal amount $1000.000) $60.00 Year 3 (6% interest on $1.00 . If you hold that bond until the very end of this term (known as the maturity date).000) date of 5 years) $1.000) $60. you’ll collect five interest payments of $60 for a total of $300.000) $60.

100.   Now. why would someone pay you $1.You could also decide to sell that bond to someone else for $1. In that case you’d earn a capital gain of $100 (plus whatever interest payments you had received in the meantime).000? .100 for a bond that only cost you $1.

however. Your original rate looks pretty good to another investor.000 bond pays 6% interest. Similar companies are now only offering a 5% interest rate on their bonds. which is called selling for a premium. interest rates have gone down. So you can sell that 6% bond at a higher cost than you paid for it. Since you bought that bond. .Selling bonds Your $1.

are like a see-saw – when interest rates go down. .However. bond prices go up (and vice versa). then. if interest rates have gone up. and similar companies are now offering 8%. you may have to sell your bond for less – which is known as selling at a discount. Interest rates and bond prices.

If you decide to just sit tight and keep your bond until maturity. you’ll face interest rate risk. In other words. You’ll keep earning your 6%. if rates have gone up.Risk factors As we've seen in the previous slide. you don’t need to worry about interest rate risk. if you decide to sell your bond before the time is up. . you may have to sell your bond at a discount. You still need to be concerned about the company's ability (assuming you purchased a corporate bond) to keep paying interest.

If business isn't going well. they might go bankrupt – meaning you stand to lose not only your 6% interest payment. Clearly a new. If things are really going badly. the company might miss a payment. but some or even all of your original investment. why would you accept the higher risk if you could get the same rate from the federal or provincial government bond? . smaller company is going to have to offer a higher rate of return to attract investors. After all.

For example. indicating their opinion of their ability to repay." that means its bonds are very highly speculative and are in danger of default of interest and principal.Easy evaluation: Ratings Not sure how to evaluate the risks associated with a corporate bond? Don't want to go through the company’s annual reports yourself? There are a number of independent firms that do nothing but evaluate the ability of bond issuers to make interest payments. Companies like Standard & Poor’s and the Dominion Bond Rating Service (DBRS) will issue a rating to each company.  You can visit these rating services at . if DBRS gives a firm a "C.

each unit would be worth $1.Mutual funds A mutual fund is really just a basketful of investments. . or units. you would have earned $5. Investors don’t buy the actual investments. of the entire basket.000 units in the fund. If you held 5 units. but rather buy shares.000. each unit will now be worth $2. Let’s say that the fund holds investments worth $100. If there is a total of 100. If the value of the investments inside the fund were to go up to $200.000.

the fund could lose money in some years if the manager miscalculates. that because a portfolio manager is buying and selling bonds in the market (and therefore subject to the interest rate risk we discussed earlier).   It’s important to keep in mind. .   Advantage: Rather than putting all of your money into one individual bond. you can spread your risk over the hundreds of companies held inside that bond basket. however. A portfolio manager will buy and sell bonds inside that fund. is basketful of individual bonds.Bond mutual funds A bond mutual fund. then. trying to get the best possible rate of return for the unitholders.

the higher the interest rate.   Generally speaking. the longer the term of the bond. Which one you buy depends on your own goals and time horizon.Types of bonds and bond funds Bonds are usually categorized as being short (under 5 years). That's because companies have to offer an incentive for investors to commit to a longer period of time. . medium (5 to 10 years) or long term (more than 10 years).

medium. but they're also more sensitive to changes in interest rates.or medium-term bonds.and longterm bonds. it's possible to buy units of a fund that only invests in long-term bonds. there are also funds that specialize in one type of bond. but so is the risk. which will hold a selection of short-. the potential for returns is higher. While there are general bond funds. For example.Long-term bonds are great for someone looking for a reliable stream of income. If prevailing interest rates go up. the price of longer term bonds will go down further than short. .

This means that bonds are great inside RRSPs. Someone who wants to speculate on new companies could buy higher risk junk bonds in the hopes of earning a high rate of return. A retired person.nvestor profile and taxation There are bonds for every kind of investor. where investments are not subject to taxation until withdrawn. but held outside of an RRSP they may not be as tax-efficient as other .   Important note to all bond-holders: Interest income is taxed at 100%. on the other hand. could buy a 20-year Government of Canada bond that would provide them with a very reliable and stable level of income.

which are traded on open exchanges. individual bond trades are made directly between buyer and seller. .Commissions and costs Unlike stocks. The commission you pay is calculated into the price of the bond – it's not charged on top the way it is on stock trades. are sold like any other mutual fund. Bond mutual funds. on the other hand. and can be purchased with or without an upfront (or back-end) commission.

we should discuss and assess your investment comfort level and define what your personal goals are. or I'll refer you to a bond specialist. Once we’ve determined the level of risk you’re prepared to accept. I'll be able to either recommend an appropriate portfolio myself.From here If you’re interested in what bonds might be able to do for you. .