How bonds work (2024)

What are bonds?

Bonds are a type of fixed-income investment. When you buy a bond, you’re lending your money to a company or a government (the bondissuer) for a set period of time (theterm). In return, the issuer pays you interest.

The term can be anywhere from less than a year to as long as 30 years. On the date the bond becomes due (thematurity date), the issuer is supposed to pay back theface valueof the bond to you in full.

Fixed income securities are one of the three main types of asset classes, which include: cash or cash equivalents such as GICs; equities or stocks, and fixed income investments.

How do you make money investing in bonds?

There are two ways to make money on bonds: through interest payments and selling a bond for more than you paid.

1. Bond interest payments

With most bonds, you’ll get regular interest payments while you hold the bond. Most bonds have a fixedinterest ratethat doesn’t change. Some have floating rates that go up or down over time. On the bond’s maturity date, you’ll get back the face value.

For example, let’s say you buy a 10-year Government of Canada bond with a face value of $5,000. And the bond pays a fixed interest rate of 4% a year. If you hold the bond until it matures at 10 years:

  • You’ll get back $5,000.
  • You’ll get back 4% in interest, or $200, a year.
  • Your return will be about $2,000 over 10 years ($200 x 10).

Floating interest bonds match the interest rate on three-monthTreasury bill (T-bills). They pay interest quarterly. If the T-bill rate goes up, you get more interest on your bonds. If the T-bill rate drops, you get less interest.

2. Selling a bond for more than you paid

In general, when interest rates go down, bond prices go up. If this happens, you can make money by selling your bond before it matures. You’ll get more than you paid for it, and you’ll keep the interest you’ve made up until the time you sell it. Learn more about how interest rates affectbond prices.

Bonds can lose money too
You can lose money on a bond if you sell it before the maturity date for less than you paid or if the issuer defaults on their payments. Before youinvest, understand the risks.

What are the types of bonds?

There are regular bonds and complex bonds. Complex bonds include strip bonds, index bonds, and real return bonds.

Regular bonds​

You buy regular bonds for a set amount of money, for a set period of time. You get regular interest payments while you hold the bond. On the maturity date, you get back the face value of the bond. They’re issued by:

  • the federal government
  • government agencies (such as the Farm Credit Corporation)
  • provincial governments
  • cities (called municipal bonds)
  • companies (called corporate bonds)

Complex bonds

Complex bonds have certain features that may improve the return on your investment. But they also have additional risks. Complex bonds include strip bonds, index bonds, and real return bonds.

1. Strip bonds

Strip bonds are created from regular government and corporate bonds. The principal amount and each interest payment are separated and sold as individual investments. You buy a strip bond at a discount. At maturity, you get the face value. The difference between the discounted value and the face value is your interest.

Strip bonds usually offer a higher yield than regular bonds with the same term and credit rating. This is because strip bonds do not make interest payments along the way that investors could reinvest or use as income. For this reason, strip bonds also tend to be affected more by changes in interest rates than regular bonds.

The secondary market (where investors buy bonds from other investors) for strip bonds isn’t as active as the secondary market for other bonds. You may not be able to sell your strip bond when you want to, or you may have to sell it for a lower price than you would like.

2. Index bonds

Index bonds keep pace with inflation. If theConsumer Price Index (CPI)goes up, so doesthe interest rate on your bond. On the other hand, because index bonds are longer-term bonds, changes in interest rates can affect their value more than other bonds.

3. Real return bonds

Real return bonds are issued by the Government of Canada and are also designed to keep pace with inflation. Twice a year, you receive interest payments adjusted to theCPI. When a real return bond matures, the amount you get back (the face value) is also adjusted for inflation.

For example, let’s sayyou buy a real return bond with a face value of $1,000 and it pays 3% interest. If the CPI goes up 1% after six months:

  • The bond’s face value will go up 1%, from $1,000 to $1,010.
  • Your interest payment for the first half of the year: $15.15 ($1,010 x half your annual interest rate = $1,010 x 1.5% = $15.15).

If the CPI goes up by 3% by the end of the year:

  • The bond’sface valuewill go up 3%, from $1,000 to $1,030.
  • Your interest payment for the second half of the year: $15.45 ($1,030 x half your annual interest rate= $1,030 x 1.5% = $15.45).

Your total interest for the year will be $30.60 ($15.15 + $15.45). A regularbondwould have paid $30 interest. With thereal returnbond, you make an additional 60 cents to coverinflation.

What happens if you hold a complex bond outside of a registered plan?

There are tax disadvantages if you hold a strip bond or a real return bond outside a registered plan, such as anRRSP, aTFSAor aRRIF. Most investments are tax sheltered while you hold them inside the plan.

For strip bonds held outside a registered plan, at tax time each year, you’ll have to calculate how much interest you earned and pay tax on it. Even though you won’t get the money until the bond matures. This is because even though you don’t receive interest payments on the strip bonds, you still earn interest annually.

For real return bonds, you don’t actually get the extra interest for inflation until the bond matures. But at tax time each year, you’ll have to calculate the extra interest you earned with inflation and pay tax on it.

How do you buy and sell bonds?

You can buy bonds from a registeredinvestment representative(sometimes known as a stockbroker).Investmentrepresentatives work for investment firms (sometimes known as brokerage firms), which are also registered. You can buy and sell bonds through a full-service firm or adiscount brokeragefirm.

1. Open an account

You can open an investmentaccountthrough a full-service ordiscountbrokerage firm. You may also choose to open a registered account, such as anRRSP, aTFSAor aRRIF.

2. Place your order

You can give your investment firm instructions to buy or sell abondin person, by phone or online. This is called placing your order. Tell the investment firm the name and amount of the bond you want to buy or sell. If it’s a new issue of bonds, the price is often theface value. Otherwise, you’ll buy or sell a bond at the currentmarket price.

Once your order is filled, the investment firm will send you a record of thetransactionby e-mail, fax or mail. It will confirm:

  • What you bought or sold.
  • The price you paid or received.
  • Any accrued interest on the bond.

Anyone selling securities or offering investment advice must be registered with their provincialsecurities regulator unless they have an exemption. Checkregistrationthrough theOntario Securities Commissionor Canadian Securities Administrators.

Learn more about working with an advisor.

What’s the difference between bonds and bond funds?

You can buy bonds on their own or as part of a bond fund. A bond fund is amutual fundorexchange-traded fund (ETF)that has invested in several different bonds. These funds often have a specific focus, such as:

  • Tracking a certain index, such as theDEX Universe Bond Index.
  • Buying bonds from a certain country, like Canada or the United States.
  • Buying government bonds.
  • Buying corporate bonds.

Before you invest, read the fund’s prospectus to understand the fund’s approach to investing and the risks.

There are five main differences between bonds and bond funds.

​Feature​Individual bonds​Bond mutual funds and ETFs
​1. Choosing investments​You or your advisor chooses individual bonds.​A professional fund manager chooses individual bonds for the fund.
​2. Risk​Risk depends on the type of bond you invest in. More variety leads to betterdiversification. Unless the issuer defaults, you will get back the face value at maturity.​Mutual funds and ETFs are diversified – they hold many investments. But risk will vary depending on the number of and types of bonds held in the fund. More variety leads to better diversification.

With a mutual fund or ETF, you could lose money. The value of most funds will change as the value of their investments goes up and down.

​3. Return​You know exactly how much interest you’ll receive and can calculate what your return will be, whether you hold the bond until maturity or sell it before the maturity date.​You generally won’t know how much you’re going to receive in any given year.

This is because the fund itself doesn’t have amaturity date. Income from a fund fluctuates as the underlyingbondinvestments change. Returns may be a combination of interest and capital gains.

​4. Buying and selling​You can buy and hold a bond to maturity and get back theface value, or you can sell it before it matures.

Your ability to sell varies depending on the type of bond. Some types of bonds, likestrip bonds, can be harder to sell than others.

​You can buy and sell mutual funds on any business day.

You can buy and sell ETFs on the exchange theytradeon, on any trading day.

​5. FeesCommissionsare built into the price of the bond.​You may pay asales chargewhen you buy or sell amutual fund.

You’ll usually pay acommissionevery time you buy and sell an ETF.

Mutual funds and ETFs charge management fees and operating expenses (known as themanagement expense ratio or MER).

How bonds work (2024)

FAQs

How do bonds really work? ›

An investor who buys a government bond is lending the government money. If an investor buys a corporate bond, the investor is lending the corporation money. Like a loan, a bond pays interest periodically and repays the principal at a stated time, known as maturity.

How do bonds work step by step? ›

Bonds are issued by governments and corporations when they want to raise money. By buying a bond, you're giving the issuer a loan, and they agree to pay you back the face value of the loan on a specific date, and to pay you periodic interest payments along the way, usually twice a year.

How to read bond quotes 32? ›

Bonds. U.S. mortgage bonds and certain corporate bonds are quoted in increments of one thirty-second (1/32) of one percent. That means that prices will be quoted as, for instance, 99-30/32 - "99 and 30 ticks", meaning 99 and 30/32 percent of the face value.

How do bonds work together? ›

Ionic bonds transfer an electron(s) and are held together by electrostatic force. Covalent bonds share electron pairs between atoms. When two atoms with large differences in electronegativity react, there is a transfer of electrons from the less electronegative atom to the more electronegative atom.

How do bonds make money? ›

A bond is a loan to a company or government that pays investors a fixed rate of return. The borrower uses the money to fund its operations, and the investor receives interest on the investment. The market value of a bond can change over time.

How does your money grow in a bond? ›

In return for buying the bonds, the investor – or bondholder– receives periodic interest payments known as coupons. The coupon payments, which may be made quarterly, twice yearly or annually, are expected to provide regular, predictable income to the investor..

How do bonds work for dummies? ›

The people who purchase a bond receive interest payments during the bond's term (or for as long as they hold the bond) at the bond's stated interest rate. When the bond matures (the term of the bond expires), the company pays back the bondholder the bond's face value.

How do bonds work in simple terms? ›

A bond is simply a loan taken out by a company. Instead of going to a bank, the company gets the money from investors who buy its bonds. In exchange for the capital, the company pays an interest coupon, which is the annual interest rate paid on a bond expressed as a percentage of the face value.

What is bond in simple words? ›

A bond is a fixed-income instrument that represents a loan made by an investor to a borrower (typically corporate or governmental). A bond could be thought of as an I.O.U. between the lender and borrower that includes the details of the loan and its payments.

How much is a $100 savings bond worth after 30 years? ›

How to get the most value from your savings bonds
Face ValuePurchase Amount30-Year Value (Purchased May 1990)
$50 Bond$100$207.36
$100 Bond$200$414.72
$500 Bond$400$1,036.80
$1,000 Bond$800$2,073.60

How to read a bond? ›

Bonds are quoted as a percentage of their $1,000 or $100 face value. 7 For example, a quote of 95 means the bond is trading at 95% of its initial face value. Face value quotes allow you to easily calculate the bond's dollar price by multiplying the quote by the face value.

How do you read a bond issue? ›

How to read a bond table
  1. Columns 1: Issuer - This is the company, province (or state), or country that is issuing the bond.
  2. Column 2: Coupon - Fixed interest rate that the issuer pays to the lender.
  3. Column 3: Maturity date - This is the date on which the borrower will pay the investors their principal back.

What triggers a bond? ›

Understanding Rate Trigger

In the case of a bond, the rate trigger may be dropping interest rates. A decline in prevailing interest rates leads an issuer of a callable bond to call that bond. Fluctuations in interest rates have implications across the economy but can be especially impactful in the bond market.

What is the strongest bond in chemistry? ›

Therefore, the order from strongest to weakest bond is Ionic bond > Covalent bond > Hydrogen bond > Vander Waals interaction.

How do bonds break apart? ›

To break the bond, you have to fight against the bond, like stretching a rubber band until it snaps. Doing this takes energy. As an analogy, think of atoms as basketballs. Think of the energy landscape of chemical bonds as a hilly terrain that the basketballs are rolling over.

Do bonds actually make money? ›

There are two ways to make money by investing in bonds. The first is to hold those bonds until their maturity date and collect interest payments on them. Bond interest is usually paid twice a year. The second way to profit from bonds is to sell them at a price that's higher than you initially paid.

Can money be lost on bonds? ›

If interest rates go up, your bond fund will decrease in value. However, the higher interest rates will provide higher dividends. Eventually, the higher dividends make up for the initial loss of value.

How do bonds work for beginners? ›

Bonds are an investment product where you agree to lend your money to a government or company at an agreed interest rate for a certain amount of time. In return, the government or company agrees to pay you interest for a certain amount of time in addition to the original face value of the bond.

References

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