A bond is effectively an IOU. When you buy a bond, you agree to loan your money to a company or government for a set period of time, at a fixed rate of interest.
Bonds are sold directly (usually to institutional investors like banks and mutual fund companies) and also to retail customers on what’s called the secondary market.
When choosing a bond, investment professionals take into account three key pieces of information: the par value, the coupon rate and the maturity date. The par value (also called the face value) tells you how much money you’ll get when the bond matures. The coupon value refers to the rate of interest the bond pays. And the maturity date tells you when you can expect the principal (the original amount) to be repaid.
One of the harder things to get your head around with bonds is the counterintuitive relationship between their value and their yield—as the price of a bond rises in the secondary market, its yield falls.
A bond’s yield can be figured out by dividing the amount of interest it will pay over a year by the current price of the bond.
So a $100 bond with a 5% yield will pay the holder $5 in interest per year. If demand for bonds rises, however, the holder may be able to sell it on the secondary market for more than the $100 he paid for it. If it’s sold for $102, the buyer will still only receive $5 in interest. That means the yield dips from 5% to 4.9%.
Who should invest in bonds?
Everyone. Bonds often form the bedrock of an investment portfolio because they are relatively predictable.
The primary risk of a bond is that the issuer may be unable to pay you back. High yield, or so-called junk bonds, feature enticingly high payout interest rates largely because their issuers know most investors doubt they’ll still be in business when the bond matures.
But most Canadian government bonds (both federal and provincial) are quite solid. U.S. Treasuries, and bonds issued by most northern European countries are also relatively safe bets.
Do you need professional help?
Without question. Buying a bond and holding it to maturity sounds simple, but new bonds are sold via auction, and institutional investors are generally the only ones with a chance of buying them at face value.
Trading bonds on the secondary market is often described as swimming with sharks; hedge funds and the proprietary trading desks of large financial institutions are staffed with people who do nothing but assess and trade bonds. All day, every day.
They know what they are doing, so don’t flatter yourself by thinking you can score bargains that they somehow miss.
A retail mutual fund designed to provide a professionally managed portfolio of bonds can be a good option for retail investors. Exchange-traded bond funds are another option. They typically provide exposure to an index that tracks either the entire bond universe or a certain slice of that universe.