Investing for Beginners – Bonds

Now that we have gone over the benefits of stocks and how they work, we will take a look at a safer investment method for those who prefer to invest without risking their principal (the money that you are using to invest). This investing method also allows you to see a steady increase in your brokerage account rather than a high amount of daily fluctuations that you would see if you had invested in stocks.

Bonds – Easy Difficulty

So what is a bond? The easiest way to describe a bond is as an IOU where you provide some liquidity – in the form of a principal – to a company or institution and in return, they provide you with a promise that they will pay you back the money in full with a fixed interest rate. When a bond is set to expire, this is what is referred to as the maturity date – the date where the contract ends, and you receive your principal back. The maturity date is when the issuer, the individual who has borrowed the money from you, is expected to repay the full amount. Bonds can be issued by almost anybody but are usually issued by companies, municipalities – provinces, cities, states – and governments to help raise cash quickly for necessities. As an example, there are many municipalities that issue bonds so that they can collect money to help rebuild roads or public buildings that are in need of renovations. 

By raising this cash, they can provide you, the lender, a fixed interest rate that can be paid out monthly, quarterly, yearly or at the end of a fixed term. Usually, the interest on bonds is paid out every year and the final year is when you would receive both the final interest payment and your principal – the money you lent them at the beginning of the transaction – with the redemption of your bond. The best way to think about a bond is like a loan agreement – you provide them with money that they can do whatever they want with and you receive in return interest and your original principal at the end of the transaction.

Bonds can also vary drastically in their lengths as some bonds can be issued for a short period of time (like 6 months), while others can be greater than 10 years. The Government of Canada provides Canadian bonds that are 10 years in length and that pay out twice a year. As an example, you have decided to purchase a 10-year Government of Canada bond for $1000. It pays twice a year and the yearly interest rate is 1%. So the first 9 years you would receive $5 twice a year for each year that you hold the bond. The 10^th and final year, you would receive $5 and another $5 with your original principal of $1000. So in the 10 years of owning this bond, you would have received $100 in interest and your original $1000 of principal for a total of $1100 on your original principal of $1000.

As you can see, there was no risk of losing your original principal as it was paid back in full by the Government of Canada. But this is not always the case. Please note that when dealing with governments or large institutions, you should expect to receive a lower interest rate as they are unlikely to default and not pay you back but when you are dealing with smaller companies, you will receive a higher interest rate as there is a potential for these companies to default. If a company defaults, you lose your principal. To help incentivize people to invest in riskier companies, these companies tend to provide a higher interest rate so that you are more willing to lend them money even though they might be riskier and have a potential to default. Also, the longer the length of the bond, the higher interest rate you will receive as your money is tied up for a longer period and you are not able to use this money for your own expenses.

So How do you Get a Return?

There are actually two ways to get a return when you invest in bonds. The first way is straightforward: you hold your bond until the maturity date – the date in which the borrower pays you back all of your money – while collecting the interest payments that are made monthly/quarterly/yearly. The second way to get a return on your bond is to sell it on a secondary market to someone else for more than what you paid for it.

So How do you Pick the Right Bond?

Picking the right bond is quite simple: there are bond rating agencies that have created standards to analyzing a bond’s worth and providing information on what the correct price of the bond should be. A AAA rated bond – usually a developed and strong government that will not default – is considered the highest rated bond and provides a low interest rate as it has almost no risk of defaulting. If you have a C rated bond – usually a small and new company – this is considered a low-rated bond with a high interest rate as it has the potential to default.

As I mentioned, bonds tend to be a very safe option for investors and is a much safer option than the stock market as they are less risky. But this low risk also comes with a significantly lower return than the stock market. If you are an individual who does not want to take on a lot of risk, you can consider investing in bonds as they are safe and will provide a return.

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