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 bonds work? ›

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.

How do you make money from bonds? ›

You can make money on a bond from interest payments and by selling it for more than you paid. You can lose money on a bond if you sell it for less than you paid or the issuer defaults on their payments.

How does a bond work in simple terms? ›

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.

What are the disadvantages of bonds? ›

Cons
  • Historically, bonds have provided lower long-term returns than stocks.
  • Bond prices fall when interest rates go up. Long-term bonds, especially, suffer from price fluctuations as interest rates rise and fall.

Do bonds pay interest monthly? ›

How often do the bonds for sale today earn interest? Both EE and I savings bonds earn interest monthly. Interest is compounded semiannually, meaning that every 6 months we apply the bond's interest rate to a new principal value.

Are bonds a good investment now? ›

Short-term bond yields are high currently, but with the Federal Reserve poised to cut interest rates investors may want to consider longer-term bonds or bond funds. High-quality bond investments remain attractive.

What bonds pay 5%? ›

Treasurys
TICKERCOMPANYYIELD
US6MU.S. 6 Month Treasury5.397
US1YU.S. 1 Year Treasury5.207
US2YU.S. 2 Year Treasury4.999
US10YU.S. 10 Year Treasury4.65
3 more rows
Feb 23, 2023

How do bonds lose value? ›

What causes bond prices to fall? Bond prices move in inverse fashion to interest rates, reflecting an important bond investing consideration known as interest rate risk. If bond yields decline, the value of bonds already on the market move higher. If bond yields rise, existing bonds lose value.

What is the semiannual interest payment on a $1000 bond with a 7% coupon rate? ›

For example, a $1,000 bond with a coupon of 7% pays $70 a year. Typically these interest payments will be semiannual, meaning the investor will receive $35 twice a year.

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

What are the pros and cons of bonds? ›

Con: You could lose out on major returns by only investing in bonds.
ProsCons
Can offer a stream of incomeExposes investors to credit and default risk
Can help diversify an investment portfolio and mitigate investment riskTypically generate lower returns than other investments
1 more row

Why do people buy bonds? ›

Investors buy bonds because: They provide a predictable income stream. Typically, bonds pay interest on a regular schedule, such as every six months. If the bonds are held to maturity, bondholders get back the entire principal, so bonds are a way to preserve capital while investing.

Is it better to hold cash or bonds? ›

Bond returns have consistently exceeded the returns of cash and cash equivalents. From 2008-2022, bonds outperformed cash by a 2.1% annual average. While 2022 was the worst-performing year in the modern history of the bond market, the year's results failed to offset the outperformance of the preceding 15 years.

Why not invest in bonds? ›

All bonds carry some degree of "credit risk," or the risk that the bond issuer may default on one or more payments before the bond reaches maturity. In the event of a default, you may lose some or all of the income you were entitled to, and even some or all of principal amount invested.

Are bonds safer than stocks? ›

Given the numerous reasons a company's business can decline, stocks are typically riskier than bonds. However, with that higher risk can come higher returns. The market's average annual return is about 10%, not accounting for inflation.

Can you make good money from bonds? ›

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.

How much profit do you make from bonds? ›

The market value of a bond can change over time. Long-term government bonds historically earn an average of 5% annual returns. A bond is also a fixed-income instrument, which is one of the three main asset classes, or groups of similar investments, frequently used in investing.

Do bonds grow your money? ›

Another difference is how they make money: stocks must grow in resale value, while bonds pay fixed interest over time. These two investment types can play essential roles in a portfolio but work in distinct ways.

How much is a $50 savings bond? ›

Total PriceTotal ValueTotal Interest
$50.00$69.94$19.94

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