Lesson 6: Why invest in fixed income?

Bonds are debt investments. When you buy a bond, you’re agreeing to lend money to a government, a company or some other institution. For their part, they agree to pay you interest for a certain period, the bond’s term. At the end of the term, the maturity date, they repay the money you loaned them, usually referred to as the principal. Depending on the bond’s conditions, you may receive interest payments at regular intervals during the term or once at the end of the term. Bonds can also have other sophisticated conditions and features built into them. For this introduction we’ll keep it simple and discuss only the basic features that apply to most bonds.

The terms bond and fixed-income investment are often used interchangeably. In fact, bonds are just one type of fixed-income investment. Fixed income also includes Guaranteed Investment Certificates (GICs), money market securities and preferred shares. This lesson focuses mainly on bonds, but you can find articles on other types of fixed income in our Fixed Income Learn section.

Bonds are often regarded as a more stable investment option as compared to stocks. When you invest in bonds, you’ll typically receive regular interest payments. This can be especially useful for people who are looking for a steady source of income or budgeting and planning their long-term cash flow.

Bonds also tend to be less volatile than stocks, with fewer dramatic fluctuations. They can provide an element of calm in your portfolio, acting as a cushion during tough economic times and volatile financial markets. Bonds may hold their value better than stocks and can help to balance out the ups and downs in your portfolio.

In short, bonds can help to provide diversification, stability, income and a degree of safety in your portfolio.

Bonds are considered lower-risk investments than stocks, but not risk-free.

Because your money will be returned when the bond matures¹, a bond is considered a relatively safe investment. However, during the time you hold your bond, its price can fluctuate. If you decide to trade or sell your bond before it matures², the price you receive is unlikely to be the same price you paid for it. Changes in interest rates and the inflation outlook will affect the bond’s price, and you may get more or less than you originally paid when you sell early. 

Risk 1: Interest rate risk

Imagine that interest rates rise after you buy a bond. You’ll be missing out on the opportunity to take advantage of those higher rates. You can wait until your bond matures and then re-invest your principal at the higher rate, but that rate may no longer be valid.

If instead, you consider selling your existing bond to re-invest, you won’t receive what you originally paid for it. Here’s why: Imagine you buy a Government of Canada bond with a 3% rate of interest. After your purchase, interest rates immediately rise and new investors who buy the same bond will now receive a 4% interest rate. Why would bond buyers want your 3% bond when they can buy a newly issued bond and receive 4%? As a result, the market price of your bond needs to adjust, and that market price will decline.

The reverse is also true. If interest rates drop to 2%, new bond buyers can only get 2% and your 3% bond becomes more appealing. Its market price will rise.

Interest rate moves can have a significant impact on bond prices, especially bonds with long maturities of 10 years or more. If you anticipate rising rates, you might prefer shorter-duration bonds, which are less sensitive to interest rate changes. Shorter-duration bonds typically have maturities of three years or less, and the price of these bonds will not decline as much as the price of longer maturity bonds when interest rates rise.

Risk 2: Credit risk

The institution that you’ve lent money to encounters some financial difficulty and its credit rating is downgraded. This can happen to countries as well as companies. The market price of your bond will drop because it’s now considered riskier, and its price must adjust to attract buyers. Both interest payments and principal of your bond may be at risk and the liquidity of the bond could decrease, making it more difficult to sell.

Risk 3: Inflation risk

Imagine that inflation rises and the return you’re getting on your bond is now less than the inflation rate. Although you may have purchased this bond so your return on your investments would at least match the rate of inflation over time, that strategy is now at risk, at least until inflation declines.

Bonds can play different roles depending on your financial goals and how long you plan to keep your money invested. By separating the strategies for bonds in a long-term investment portfolio from those you might buy for shorter-term goals, you can make sure your bond investments fit well with your overall financial plan. Knowing these differences will help you make smarter choices and ensure your bonds work for you in the way you need.

Short to medium time horizon

When you’re saving for short- to medium-term financial goals, like buying a car or funding a wedding, shorter-term fixed-income instruments can be a smart choice. For example, if you plan to buy a car in three years, you might consider investing in short-term bonds or GICs that mature around that time. This way, you can earn some interest while keeping your money relatively safe and accessible when you need it. Short-term bonds and GICs are less affected by interest rate changes as compared to long-term bonds, so you won’t have to worry as much about losing value if rates go up. Again, if you hold a bond until maturity, you’ll receive your principal back along with the interest payments, except in the rare case of bond default.

Longer time horizon

If you’re thinking about long-term goals, like retirement or buying a home in the future, bonds can help provide stability and income over time. For instance, if you’re planning to buy a house in ten years, you might invest in a mix of intermediate and long-term bonds. This might include corporate bonds, which can offer higher yields than government bonds. By including a variety of bonds in your long-term strategy, you can create a more secure financial foundation with diversified sources of income.

Just as you diversify your stock investments, you’ll probably want to diversify your bond holdings, especially with a long time horizon. Consider a mix of different types of bonds, such as government bonds, provincial bonds and corporate bonds.

You might also consider including bonds with varying maturities — short-, intermediate- and long-term — to balance interest rate risk, as this structure lets you reinvest the amounts that will reach maturity at different times. This diversification can help reduce the impact of any single bond’s performance on your overall portfolio. A diversified bond ETF or mutual fund can also provide a mix of bond holdings in one product. We discuss this below.

When diversifying, remember that government bonds from developed economies are generally considered safer than corporate bonds, especially from companies with lower credit ratings. Evaluate your risk tolerance to determine how much risk you’re willing to take on in the bond portion of your portfolio. If you are risk-averse, meaning less comfortable with risk, focus on highly rated government bonds or high-quality, investment-grade corporate bonds. To refresh your understanding of risk tolerance, see Lesson 2 in this course.

Investing in individual bonds can be quite different from putting money into bond funds or ETFs, especially for new investors. One challenge is that many individual bonds require a large minimum investment, usually at least $1,000, but sometimes much higher. This can make it hard for smaller investors to spread their money across different bonds. Additionally, some individual bonds are not that liquid and can be difficult to buy or sell quickly. This might limit your ability to react to market changes or access your money without compromising on price if you need it on short notice.

The price you pay for a bond may include a markup that compensates the dealer or broker, which can effectively act as a commission. Finally, you’ll need to do your own research to understand the creditworthiness of the bond issuer and the bond's terms. This may require some financial knowledge and can be time-consuming.

On the other hand, bond mutual funds and ETFs allow you to invest in many bonds with one purchase and a smaller amount of money, offering instant diversification and easier trading. However, they typically charge fees, such as management fees ranging from 0.1% to 1% or more annually. Other expenses like trading commissions may also apply. While these funds may not give you the same level of control as individual bonds, they can be a more accessible choice for new investors. Each option has its own risks and costs, so it's important to learn about both before investing.