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What Are Bonds and How to Invest in Them?

A bond is a fixed income instrument that is issued by corporations or governments when they want to raise some money. When you invest in bonds, you lend money for a specific period of time, and you are paid back with a fixed interest percent on your amount.

You can consider bonds similar to a bank loan, only the roles are reversed. You are the lender i.e. you are providing capital and the borrower has to pay you back with added interest on your principal amount.

If you understand certain basic characteristics of a bond, then investing in bonds becomes quite simple. The face value of a bond is the price at which you buy the bond. The date on which investors get their principal amount back is the date of maturity and finally, the coupon is the interest you earn on your principal amount.

Types of bonds for Canadians

According to income, before investing in bonds, you should know that there are three basic types of bonds for Canadians:

Canada Savings Bonds: These are bonds issued by the government of Canada to raise funds for large developmental projects in the country. There are various bonds available that vary in maturity date and interest rate. Government bonds are generally considered the safest bonds as they are least likely to default on principal and interest payments.

Municipal Bonds: These bonds are issued by municipalities or states in order to raise funds for smaller developmental projects like constructing a park in the city. Similar to government bonds, there are various bonds available depending on the interest rate and length of time. Municipal bonds give you a better interest rate as compared to government bonds as they carry higher risks.

Corporate Bonds: Companies issue bonds to investors so they can generate income for different projects that will help the company to grow and expand. The structure is similar to other bonds and they also offer comparatively higher interest rates.

The only point investors should know is that corporate bonds are riskier as individual companies are much more volatile than the overall economy and if they incur a loss or go bankrupt, there is a chance that you don’t receive your initial investment.

How to Invest in Bonds?

Unlike stocks, bonds are not traded on a stock market. You need to buy bonds through a broker and with that, you also need a good initial amount to begin with as interest rates are nearing record lows in 2020.

In the case of Canada Savings Bonds or Canada Premium Bonds which are issued by the government, you can buy them through financial institutions, banks, or investment firms.

When you buy a bond, you buy it at a fixed rate and earn a fixed interest on that amount. But after a bond is issued, its price can fluctuate in the secondary market. So, an investor can also sell it in the market and profit from the difference amount.

You can invest in bond funds as this has the least risk involved due to diversification. In this case, a fund manager pools money from different investors and manages it into various individual bonds, which is similar to investing in an ETF.

According to TheMotleyFool, you can profit in two ways from bond investments. You can wait for the bond to mature and receive your investment back with interest or you can sell the bond at a rate higher than your buying amount.

Selecting a good bond investment

According to nerdwallet, an investor should check whether the company you are buying bonds from is capable of paying you back with interest. You can do this by researching it a little. You can also look at a company’s income statement and compare their income with the interest rate they are offering on the bond.

Generally, if a company offers an interest rate from 2.5% to 4% it can be considered a good company to invest in, but, you should look at other aspects too including profitability and free cash flow. 

Trying to decide when to buy a bond is like timing the market, which is very difficult to predict. So, investors may use the ladder effect to gain maximum returns i.e. you buy a number of bonds that will mature over time, and after maturity, you invest the principal amount again. This will diversify the interest rate risk and provide you with a steady stream of recurring income.

Bonds are a great investment option when you are nearing retirement. The older generation of retirees prefers to buy bonds as these instruments are less risky and considered a safer investment tool. Here investors can always include some percent of their portfolio in bonds as you get a steady stream of income and most of the time you get your money back.

The Bullish verdict

Generally, the amount you invest in bonds depends on your age. As a thumb rule, if you are 30 years old, you can allocate 30% in bonds and 70% in stocks.

Whether investing in bonds is the right decision for you or not depends entirely on you. If you are someone with a low-risk appetite, then bonds are a more suitable option for you. And if you are already investing in stocks, bonds will give your portfolio diversification.

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