I’ve been getting a lot of similar questions lately. What are bonds? Why should I care? Why are you wasting your time on this silly moose website?
I’ll answer some of those questions. Turn on the thinking part of your brain…. now… and here we go with bonds!
What is a bond?
A debt issued to some entity where YOU act as the issuer and collect interest. (You loan money and they eventually give it back plus some extra)
You give the government or a corporation some money, say $1000, and they promise to pay you interest, say 6%, over a specified time frame, say two years. At the end of the two years you’ll get your $1000 back plus $60 interest for a total of $1060.
Bonds are issued by governments and corporations to gain access to cold hard cash for various long term projects like World War II. Corporations prefer bonds over direct bank loans because bonds offer more flexibility. Banks are strict on what you spend their money on and won’t give you anything more till you pay back the first loan.
Governments typically don’t take loans from banks and thus will normally issue bonds to raise cash or cover a deficit. Alternatively the government can just print more money but that’ll weaken the currency on the open market and thus weaken the country.
How is this different from a GIC? Also, what’s a GIC?
A Guaranteed Investment Certificate(GIC) is an investment sold by a bank that provides a guaranteed return over a specified time frame.
GICs are normally issued by banks, not corporations or governments, and as the name implies is guaranteed. The word guarantee is a strong statement, but these banks have been pretty reliable these past few centuries. Bond values can change over time(more on that later) and thus their value is not guaranteed. A bond can also be SOLD at any time whereas a GIC is completely locked up for its duration.
Why should I buy bonds?
You’ve probably heard that people need 30% bonds and 70% stocks. There are reasons for that:
- Diversification – During wild market fluctuations bonds will normally do the opposite of stocks and owning both will make your portfolio less volatile. Some bond funds during the 2008 crash gained 11% while stocks fell 20%
- Stability – Bond prices may rise and fall slightly but they are seriously more stable than stocks. Check out the graph below.
- Income – Cash payouts from bonds remain fairly constant even if the bond price dances all over the place. Most bonds payout twice a year and can be used as a reliable source of passive retirement income.
Ok I’m convinced, how do I buy bonds?
The easiest way to buy individual bonds is through your brokerage. Questrade offers zero commissions on bond trades. You will normally call the bond department of the brokerage to place an order. Government bonds can be purchased through the Government of Canada website. They’ll even mail you a fancy bond certificate!
How else do I buy bonds?
ETFs – You guessed it, bonds also come in ETFs! With a bond ETF you can buy a small fraction of 1000 different bonds at once rather than a single bond. You can buy them just like a stock through your brokerage and can easily target a bond market, like government or corporate.
Vanguard’s Canadian Aggregate Bond ETF holds 770 different bonds, mostly government, it has an annual dividend (or distribution as they call it with bonds) of 3.3% which is paid monthly.
What else should I know?
- Relationship between bonds and interest rates – Maybe you’ve heard that such a relationship exists. Well it does. And to put it simply, if the government reduces interest rates, bond prices go up, and vice versa. It’s an INVERSE relationship and one of the main reasons bond prices fluctuate.
- Relationship between bonds and stocks – You should know this already, typically bonds will fall (slightly) when stocks rise and vice versa. Another INVERSE relationship.
- Bond strategy – Infiltrate the Russian compound and steal the intel without alerting the guards…. wait…. wrong Bond again.
- Bond strategy – Bonds are your safety net. A conservative profile will be mostly bonds. If you’re under 30 you should hold about 15% in bonds, gradually increasing that to at least 60% at the start of retirement. Thus if the market crashes you’ll at least retain some of your capital within the bonds.
Why would interest rates matter?
It will make sense with an example. Let’s say you buy a bond at $1000 paying 5%. You will eventually get back a total of $1050. But the next day interest rates rise to 10%. You decide to sell your first bond and buy a new one that gives 10%. Unfortunately you can’t find a chump to buy your sissy 5% bond when they can just as easily walk across the street and get 10%. The only solution is to lower your selling price to artificially give a 10% return.
You manage to sell your $1000 bond for $954.55. Had you kept it you would have earned $50, but the new owner will earn $95.45 ($50 plus your discount of $45.45) which is 10% of $954.55. Summarized below:
|5% interest||10% interest (new owner)||Difference|
|Value at purchase||$1000||$954.55||-$45.45|
|Value at maturity||$1050||$1050||–|
Whoever issued the bond pays the exact same no matter who owns it. But as you can see the $45 was transferred between owners because of the interest rate change.
There! You’re now smarter! You can smugly talk about interest rates affecting your investments!