As a Qualified Associate Financial Planner I’m asked a variety of financial questions. But one topic I never get asked about is bonds. The stereotypical middle child of investments – often overlooked – unless they start acting up. So, let’s start talking about them: what they are, how they make or lose money and where they might fit into a portfolio?
What are Bonds?
Simply put, bonds are loans taken out by governments and corporations. Unlike you or I who can go to a bank, governments and corporations need vast sums for their projects. Banks don’t want to take on the risk of a loan that size, at least not by themselves, which is where bonds come in.
Here's an example of how it works, a province needs millions to build a highway, so they create a bond. They secure it against property or equipment they own and set an interest rate (called a coupon) and a maturity date. The bond is then put on the bond market where it can be bought and sold until maturity.
How to Make or Lose Money in Bonds?
There are two ways to make money with a bond. One, you collect the coupon until it matures and then recoup the loan (or face value of your bond) when it matures – simple, straightforward.
Alternatively, bonds can be traded. After their initial release, bonds aren’t traded at their face value rather their perceived value which can fluctuate on factors such as inflation, a borrower's credit rating and market sentiment. For example, buyers are willing to pay more than the face value for an older, 5% bond if new bonds are being created with 3% coupons. Inversely buyers will offer less than face value on the lower 3% coupons.
Therefore, selling higher than your purchase price makes money and inversely selling at a lower price loses money. It’s worth noting that a profit or loss is not realized until a bond is sold – or matures.
Portfolios & Bonds
Stocks and bonds are usually seen as inverse investments since historically when one performs well, the other’s performance is lagging. It’s exceedingly rare for stocks and bonds to move together. Bonds are also seen as a lower-risk option then stocks. This doesn’t mean bonds have no risk however, since they generate a steady income and are usually secured against real assets, they are deemed less risky. Therefore, the more bonds your portfolio holds, compared to stocks, the lower the risk rating.
Most investors hold bonds in their portfolio through mutual funds or ETFs over owning bonds directly. This is because investment institutions such as mutual fund companies have the resources and insight to trade enormous quantities of bonds - offering more flexibility and diversity.
Even if they’re rarely discussed, bonds provide a variety of opportunities and strategies that can complement a portfolio. If you want to know more about bonds or bond strategies, contact your Q Wealth Associate Portfolio Manager.
- Courtney Beach, QAFP
