Bonds are back in the conversation. In 2022 when central banks started raising interest rates to combat inflation, the interest paid on new deposits, GICs and bonds have also risen.
Specifically, for bonds, the discussion of utilizing increasing interest rates to raise portfolio returns while diversifying has become more prevalent. The belief in “TINA”, There Is No Alternative to equities despite their less than stellar performance, is waning.
Understanding the basics of bonds, and the principles of yield and return, in addition to risk, is necessary before deciding the value of moving-into bonds as an investment strategy.
What you need to know
Firstly, a bond is a debt issued by a company or government. The investor buys this debt obligation and receives, typically, regular interest payments. At the end of the bond’s term, the debt is repaid. Bonds fall into the “fixed income” asset class since they are designed to deliver predictable periodic payments. It should be noted that bonds are not only purchased when issued on the primary market, they are also traded in a secondary market.
As prevailing interest rates change, the selling price of the bond increases or decreases on the secondary market. The price moves to keep the bond generating a yield that mirrors the prevailing rates of interest. If interest rates rise, bond prices typically fall, and vice versa.
At 4% interest, a $1,000 face-value bond generates $40 interest. If rates rise to 5%, the bond’s price would need to fall to $800 to have the $40 payment equal 5% of the bond’s value. The secondary market encapsulates many more attributes and conditions than interest rates.
The selling price incorporates the risk of default (payments and repayment at maturity), the amount of the periodic payment and whether the bond is sold at a discount (below its face value) or at a premium (above its face value) and time to maturity.
With payment and the possibility of gains/losses, a bond offers income opportunities with two different tax treatments. If it is held outside of a “registered” account like an RRSP or TFSA where income tax is either deferred or not applicable, the regular payments are treated as interest income and a positive increase realized at maturity is taxed as a capital gain.
For example: A $1,000 bond that was purchased on the secondary market for $950 and pays 4% interest will generate $40 of annual interest and a $50 capital gain at maturity, if obligations are met. Government of Canada Treasury Bill (T-Bills) or a stripped bond is purchased at issuance and at a discount and held to maturity. The gain is treated as interest by CRA.
The Bottom Line
Bonds offer both fixed income and capital gain income opportunities. Prices fluctuate on a secondary market that reacts to several factors. The secondary market offers no guaranteed like GICs but does provide liquidity. The tax treatment is straightforward, but not necessarily intuitive if bonds are held outside “registered” accounts.
