By Tessa Wilmott
Investing in bonds (whether directly or in a bond mutual fund) can add to your investment portfolio.
A bond is a loan. When you buy a bond, you are lending money to its issuer, whether a government or a corporation. The issuer undertakes to pay you interest at fixed intervals (the “coupon”) for a fixed period and to repay the principal at the end of this period (that is to say when the bond matures due date). So if you buy and keep a bond, your money is refunded, and you will have earned interest.
“It takes some of the uncertainty out of investing,” says Andrew Allentuck, author of Bonds for Canadians: How to Build Wealth and Lower Risk in your Portfolio.
Of course, all uncertainty is not removed. In real life, you must carefully choose the entity to whom you will lend money: sometimes, borrowers do not repay the loans they have taken out. But if you buy a bond issued by a stable government, like Canada’s, your principal will most likely be repaid when the bond matures, and you will have earned regular interest in the meantime.
The same principle applies to purchasing a bond issued by a company. It would help if you made sure that the company has the capital to repay the principal plus interest and that it has a good reputation in this regard. (Be especially careful with bonds offering high-interest rates, known as “high yield bonds”; the issuer may provide a high-interest rate because its financial situation might not attract investors. buyers at lower rates.) Another thing to consider is that companies may attach various covenants and conditions to their bonds, which you should make sure you understand.
You can sell your bond before it matures, but this introduces a new element of risk. The relationship between bonds and interest rates is reversed. If interest rates are high and bond prices are low, you may sell your bond for less than you bought it. On the other hand, if interest rates are low, you might be able to sell your bond at a profit.
However, bonds do not trade like most stocks, i.e. on an investor-friendly exchange. Getting the current bond price requires more research, which might require you to go to a broker. As Christopher Davis, director of fund analysis at Morningstar Canada in Toronto, explains, bond pricing is less transparent than other securities.
Bond funds
If you’re not prepared to do the research required to buy bonds, investing your money in a bond fund — a type of mutual fund that buys bonds rather than stocks — might be a good option. You would be putting your money in the hands of professional fund managers. These track economic conditions and interest rates and diversify the fund’s assets among several bonds, increasing the possibility that the fund’s return will be higher than that of a bond you would have purchased directly…
Tax is also a factor to consider. The interest payments are taxed as interest income if you buy bonds directly. If you sell the bond before it matures, your gain — or loss — is subject to the lower capital gains tax payable. A capital gain or loss will also apply if you hold a bond to maturity but bought it at a price different from its face value. On the other hand, if you have bonds in a registered account, taxation is deferred until you withdraw the money from that account.
Buying bonds directly or owning a bond fund depends on your financial needs, risk tolerance, savings size, and even your tax situation.
