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 and they agree to pay you interest for a certain period of time for the use of that money. At the end of the agreement, also known as the maturity date, they repay the money you loaned them, usually referred to as the principal. Most of us are familiar with taking out a loan or mortgage. When you buy a bond, someone else is taking out a loan with you.

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

Bonds also tend to be less volatile than stocks and can provide an element of calm in your portfolio. They may act as a cushion during tough times and volatile financial markets. For example, if the stock market is going through a rough patch, 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 lower risk, but not risk-free.

When they’re held to maturity, high-quality bonds are generally considered conservative investments. But like any investment, fixed-income securities have certain risks, including price fluctuation. Price fluctuation risk, or partial loss of principal, can occur when you sell your bond before its maturity date. If interest rates have risen since you purchased the bond and you sell it before maturity, you’ll likely receive less than what you originally paid for it. Selling before maturity could work to your advantage, however, because your bond can also gain in value under the right circumstances.

Here's a summary of common risks when investing in bonds:

1. Credit Risk: When you invest in a bond, you’re lending money to the issuer (e.g., a government, company, or some other institution) in exchange for regular interest payments and the return of your principal when the bond matures. The issuer is responsible for paying the interest and returning your principal on time. However, if the issuer experiences financial difficulties and defaults on their payments, your income stream could stop and the return of your principal could be at risk. This is known as credit risk.
2. Interest Rate Risk: The value of a bond is also impacted by changes in interest rates. When interest rates rise, the value of existing bonds can fall, potentially reducing your returns. This is known as interest rate risk. However, if you hold the bond to maturity you’ll receive your original investment, all else being equal.
3. Inflation Risk: Inflation can erode the purchasing power of your money over time. If your bond pays an interest rate that’s lower than inflation, the inflation-adjusted value of your investment will be lower when your bond matures. In other words, while you’ll receive interest over the life of the bond and the original amount you invested will be returned at maturity, that combined amount will have less purchasing power than when you originally invested it.

The factors that create risk for bond investors are also the main factors that affect bond prices. These are primarily the current level of interest rates and the credit rating of the bond issuer (in other words, how creditworthy is the institution that you are lending money to).

The impact of interest rate changes on bond prices

If interest rates fall, the market prices of existing bonds rise. If interest rates rise, existing bond market prices fall.

Imagine that you bought a Government of Canada bond, which means that you agreed to lend the Canadian government some money at a certain interest rate for a specified time. Let’s say the interest rate you’ll receive on this bond is 3%. After you purchase the bond, interest rates immediately fall and new investors who purchase the same bond now receive an interest rate of 2%.

Since you own a bond that pays 3% and that’s more than what new bond buyers will receive, your 3% bond becomes more valuable and the market price of your bond rises.

The reverse scenario is also true. If interest rates rise to 4%, new bond buyers can get 4%. Your 3% bond becomes less appealing and its market price declines.

The impact of creditworthiness on bond prices

A lower credit rating means the borrower must pay a higher rate of interest to attract investors and vice versa. If you’re holding a bond from an issuer whose credit rating changes, the market price of your bond may adjust. If the credit rating improves, the bond’s market price will likely rise. If the credit rating declines, the bond’s market price will likely fall.

This is probably a fairly easy concept to understand if you’ve ever applied for a loan. If your credit history is excellent, lenders are willing to lend to you at a lower interest rate. Those whose history is not as good will probably be required to pay a higher rate because they’re higher credit risks.

The same thinking applies to all bonds, whether it’s a country, company or an individual borrowing money. Those perceived as lower credit risks can issue or take on debt at a lower interest rate.

There are several ways you can invest in bonds — each with its own  pros and cons. Here are a few options to consider:

1. Individual bonds: You can choose individual bonds and buy them online through Investor’s Edge or call a representative to place your order. You decide what and when to buy and sell. When the bond matures, you receive your principal back or you can sell the bond in the marketplace at the prevailing market price before it matures.
2. Bond mutual funds: With bond mutual funds, you get exposure to many different bond issuers and maturities in one investment vehicle. Bond funds can be a good choice if you're looking for a convenient and easy way to invest in bonds. The bond fund manager determines the mix of bonds in the fund.
3. Bond exchange-traded funds (ETFs): With bond ETFs you also get a mix of different types of bonds. The bond ETF will often track a bond index, so there is typically no manager expressing their opinion on the mix of the ETF. You as the investor will need to research the different kinds of ETF available and what distinguishes one from the other.
4. Bond ladders: This is a strategy where you invest in individual bonds with different maturities, so you have a steady stream of income over time. Bond ladders may be a good choice if you're looking for a predictable and steady source of income from your bond investments. They work especially well to smooth out interest rate fluctuations because you can take advantage of current interest rates as individual bonds mature at different times.

Investors who buy individual bonds can face different challenges than those who invest in bond funds or ETFs. Here's why:

• Minimum investment amounts: Many individual bonds have minimum investment amounts, which can be as high as $100,000 or more. This can make it difficult for small investors to diversify their bond investments across multiple issuers.
• Market liquidity: Some individual bonds may not be very liquid, meaning it can be difficult to buy or sell them when you need to. This can make it harder for small investors to quickly respond to changes in the market and can affect the market price of the bond.
• Research: Investing in individual bonds means you’ll need to do your own research and understand the creditworthiness of the issuer, the terms of the bond, and other factors that can impact your investment. This can be time-consuming and requires a certain level of financial knowledge.

Bond funds and bond ETFs allow you to invest in a large number of bonds with a relatively small amount of money. They also provide instant diversification and are generally easier to buy and sell than individual bonds. However, they may not provide the same level of control and customization as investing in individual bonds. Like all investments, bond funds and ETFs come with their own unique risks, fees and uncertainties, so it's important to do your research and understand how they work before you invest.