It might not garner the attention that stocks do, but the bond market is actually bigger than people think. In fact, a 2023 Statistics Canada report placed the market value of debt securities (i.e., bonds) at about $5.258 trillion in Canada, whereas equity securities (i.e., stocks) totalled roughly $3.870 trillion.

Bonds have a long history of being used to reduce debt or help finance business or government projects and operations, so its market size shouldn’t be surprising. Let’s consider the basics of bonds, what types exist and how you can invest in bonds for your own portfolio.

What are bonds?

A bond is a loan agreement between the borrower (a company or government body) and lender (investors). Simply put, a bond provides capital to the borrower in exchange for interest payments and repayment of the bond’s principal amount at maturity. For example, if an investor buys $20,000 of a new bond that matures in 2035 and pays annual interest of 4% (called the “coupon rate”), they should expect to receive $800 per year (20,000 x 0.04) in interest payments and get back their original $20,000 investment in 2035.

Note that interest paid on standard bonds is fixed at a certain rate, which is why bonds are also referred to as “fixed income.” As with stocks, bond prices rise and fall. When issued, bonds are usually priced at $1,000 (called its “par value”), but may trade above or below $1,000 according to market conditions (when the bond matures, investors receive the par value of $1,000).

Continuing with our example, if market interest rates rise above the bond’s 4% coupon rate, then prospective investors won’t find 4% desirable. Since the coupon rate is fixed, the bond price should dip below par value. That way, investors buy the bond at a discounted price to compensate for earning less interest than bonds issued today. They’ll pay less than $1,000 for the bond, but stand to receive the full $1,000 at maturity. If market rates decline below the bond’s 4% coupon rate, investors will pay more than par value to collect higher interest payments than what’s currently available.

Types of bonds

While bonds come in many different forms, here are some common ones:

• Corporate vs. government.
  As discussed, companies and governments issue bonds when needing access to capital. Generally, government bonds have lower risk of default because they’re backed by significant assets. Again in general terms, federal bonds are more stable than provincial bonds, which in turn are often more stable than municipal bonds. The level of corporate bond risk varies depending on each company’s financial strength.
  
  
• Investment grade vs. high yield.
  Bond rating agencies conduct research and analysis before assigning a rating for a bond’s creditworthiness. Bonds rated “investment grade” have lower default risk, while “high-yield” bonds have higher default risk. Since investment-grade bonds demonstrate more financial strength, the issuer doesn’t need high coupon rates to entice investors. Conversely, a riskier high-yield bond might only attract investment by offering a higher-paying coupon.
  
  
• Callable vs. convertible. If a bond is “callable,” the issuer may redeem it before the maturity date. If market rates decline, they can save money by redeeming this bond and issuing another at a lower coupon rate. When a bond is “convertible,” the investor may convert their bond holding into shares of the issuer’s stock. Conversion may take place at specified times and for a predetermined number of shares, so the investor can decide whether it’s attractive to convert at the prevailing share price.

Why invest in bonds?

Bonds generate regular income, which is valuable for investors wanting steady cash flow (e.g., retirees). Bonds also help “balance” an investment portfolio because, under certain market/economic conditions, stocks may thrive and bonds may decline, or vice versa. This diversification could improve a portfolio’s overall risk-return potential.

For exposure to a range of bonds – such as those from different industries, with different ratings or offering different features – consider convenient mutual funds or exchange-traded funds. You’ll be investing in a professionally managed bond portfolio without doing the research, analysis and monitoring yourself. Consult with an Alterna Advisor to see if bonds could be suitable for your portfolio.