Bonds 101

Bonds 101

In a volatile market, it is a strong risk management strategy to diversify your investment portfolio with different asset classes. Stocks offer great potential, but bonds can add balance. Bonds are promissory notes issued by a corporation or government to its lenders, usually with a specified amount of interest for a specified length of time. They are an effective way to hedge against market volatility as they typically trend in the opposite direction of stocks, and they are commission-free.

What is a bond?

A bond is a debt investment. An investor loans money to an entity (corporation or government), which borrows the funds for a defined period (until the maturity date) at a fixed rate of interest (the coupon rate).
Bonds are commonly called fixed-income securities and are one of the three main asset classes, the other two being equities (stocks) and cash equivalents.

Bonds are generally viewed as safer investments than stocks because bond volatility (especially short- and medium-dated bonds) is often lower than that of stocks. However, like any investment, bonds are subject to investment risk.

Understanding bond quotes

A bond’s quote is a statement of its price as expressed in terms of a percentage of the bond’s face value or dollar value. Corporate bonds are usually quoted in 1/8th increments, while government bonds are typically quoted in 1/32nd increments.

For example, a corporate bond with a quote of 99 1/8 or $991.25 represents 99.125% of par ($1,000), which is the amount repaid to the investor when a bond matures.

What is bond liquidity?

Liquidity refers to how easy it is to sell a bond.Highly liquid bonds, such as treasuries and blue-chip corporation debt, trade frequently. Illiquid bonds, such as those of a company close to bankruptcy, would trade much less frequently.

What determines the price of a bond?

The price of a bond is the sum of the present value of all expected future coupon payments (interest rate payments) and principal payments discounted at the bond's redemption yield or rate of return. The redemption yield may be the current yield plus the expected capital gain or loss.

When investing in a bond, its valuation is only one of several factors to consider: the issuing company’s creditworthiness, the bond's price appreciation potential, and prevailing and projected market interest rates also play important roles.

What’s the difference between bonds, term deposits, and GICs?

A bond is essentially a loan to an organization with a pre-set coupon (return) rate and maturity date. GICs and term deposits are guaranteed investments with set terms and interest rates.

Are bonds guaranteed to earn interest?

Bonds have a pre-determined coupon or interest rate. With bonds, your money is not guaranteed. They are generally a safer way to invest, but they still carry some degree of risk.

Bonds vs. stocks

  Bond Stock
Definition A note payable (debt investment) A title of ownership (equity investment)
The investor Long-term creditor of the issuing company Owner of the issuing company (i.e. possessor of an equity stake)
The capital contributed Is a liability Is the shareholder's equity
Investor rights No rights over the company's assets other than the principal and interest payments of the bonds, but a higher claim on assets than a stockholder Can use all partnership rights vested to them, which may include voting rights
Term The relationship between the bond holder and the company ends when all interest and principal payments are paid in full, which is usually at the end of the term No term limit; the relationship between the stockholder and the company ends when the equity is sold
Payment to investors Known and fixed (with the exception of floating-rate bonds) Dividend payments are set by the company's board of directors and are subject to change
Value Sellers can set the price for their bonds higher, lower, or at par, but the true value can only be realized at some point in the future Equivalent to market price, which is determined by current bids and offers on a central stock exchange
Issuers Companies and public institutions Public companies that meet the listing requirements of the stock exchange
Redemption Redeemed according to the terms at issuance Partial redemption can occur if the company chooses to buy back shares. Full redemption only occurs if there is a change in company ownership

Common bond terminology

Some platforms may require additional data to trade Canadian options. Here is an overview of terminology that may appear in this data.

  • Par (or par value): the face value of a bond (generally $1,000). It is the amount paid to the holder on the bond's maturity date.
  • Coupon (or coupon rate or coupon percent rate): the rate of interest the bondholder will receive. It is typically stated as a percentage of the face value and is paid semi-annually.
    Example: a $1,000 bond with a coupon of 6% will pay $30 every six months ($60 a year).
  • Yield: the return an investor gets on a bond. There are two important types of yields:

    • Current yield: the annual return on the dollar paid for the bond; interest rate divided by current price.
    • Yield to maturity (YTM): the rate of return anticipated on a bond if it is held until the maturity date. It takes into account the current market price, par value, coupon rate, and time to maturity. It is assumed that all coupons are reinvested at the same rate.
  • Maturity: the length of time until the principal amount of the bond must be repaid. Maturity is the date by which the borrower must pay back the money borrowed through the issue of the bond.
  • Basis point: a unit for measuring a bond’s yield. One basis point equals 1/100th of 1% of yield (i.e. 100 basis points are equal to 1% of yield).
  • Accrued interest: the interest that has accumulated on a bond since the last interest (coupon) payment.
  • Yield curve: a line that plots interest rates, at a set point in time, of bonds having equal credit quality, but differing maturity dates. The most frequently reported yield curve compares three-month, five-year, and 30-year debt.

    The shape of the yield curve is closely analyzed because it indicates future interest rate changes and economic activity:

    • Normal yield curve: longer maturity bonds have a higher yield compared to shorter-term bonds due to the risks associated with the longer period. The greater the slope, the greater the gap between short- and long-term rates.
    • Inverted yield curve: shorter-term yields are higher than longer term yields.
    • Flat yield curve: shorter- and longer-term yields are very similar.
    • Humped yield curve: short- and long-term yields are similar, but medium-term yields are higher.