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Investment Basics

Bonds - Connecting your investment objectives

We may think bonds are pedestrian or dull. Their glamorous cousins, stocks, receive most of the press even though the annual North American bond market is much bigger than the stock markets.

A bond is a contractual obligation to pay a debt. The bond issuer promises to pay a specific amount of interest on specific dates for a specific length of time, and to repay the debt upon maturity. Sometimes the term "bond" is used to include debentures but, strictly speaking, bonds are secured by a specific asset, while debentures are "IOU's" secured by the issuer's general credit.

Bondholders receive interest if they hold their bonds, and may make a capital gain or suffer a capital loss if they sell them.

Bonds and debentures are issued in Canada by all levels of government, agencies, crown corporations, religious and educational organisations, and corporations.

Choosing between bonds and stocks depends on your principal investment objectives - safety, income, growth, and liquidity.

Safety is usually obtained at the expense of return and growth. Government of Canada T-bills; most federal, provincial, and municipal bonds; investment-grade corporate bonds; and short-term bonds close to their maturity dates are generally considered safe investments.

Bonds are rated by independent bond-rating agencies that assess the level of risk. Rating scales run from A to D, with A and B ratings considered investment-grade. One safety feature of bonds is that, in the case of an issuer default, bondholders are ahead of stockholders in the queue to reclaim their investment.

Income is where bonds are strong, with their promise of specific interest payments at specific times. Generally, an investor has to give up some safety in order to maximise income. This is the basis for the "junk bond" or "speculative bond" market where bonds rated "C" or below promise higher returns with more risk.

Growth of capital is very limited with bonds, unless you invest in a bond mutual fund or actively trade bonds yourself. Because the interest paid on a bond is fixed, investors move elsewhere in times of increasing inflation, and the value of a fixed-interest bond decreases. However, when interest rates are going down, bonds increase in value.

Liquidity is a measure of the ability to buy or sell an investment without price fluctuation. Canada Savings Bonds, T-bills, and investment-grade bonds are generally considered to be liquid investments. If you need cash, you can find a buyer without sacrificing price.

The following table compares bonds, preferred stocks, and common stocks on the first three investment objectives:

Investment Safety Income Growth
Short-Term Bonds Best Very Steady Very Limited
Long-Term Bonds Next Best Very Steady Variable
Preferred Stocks Good Steady Variable
Common Stocks Often the Least Variable Often the Most

While you can buy and sell bonds directly, the usual method of bond investing is with a bond mutual fund. The fund manager buys and sells, depending on an assessment of the direction of interest rates, and pays dividends based on a combination of interest received and capital gains.

Your decision to invest in bonds should be based on your principal investment objectives. Ask your investment advisor about bonds to decide if they are right for you.

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