Bonds & Interest Rates – an Introduction

A number of investors have been asking me about bonds and bond mutual funds lately, so here is a bit of a primer.

Interestingly, in dollar terms, the bond market is far larger than the stock market.
Bonds are debt instruments, similar to a loan to be exact - a promise to pay back principal along with interest. Bonds can be issued by governments or corporations. Keep in mind that there is a big difference in credit worthiness between government bonds and corporate bonds issued by companies.

A government bond is backed by a government. In Canada for instance, federal and provincial bonds dominate most of the trading.  A corporate bond is backed by the corporation who issued it. You should be aware that if the company goes bankrupt, your bond may be worthless. On the other hand, a Canadian federal government bond is backed by our own government and is not likely to ever default on its own bond. Even though Canada has a AAA (triple “A”) credit rating (the highest possible), there is another "risk" you should be aware of. This risk is related to the everyday fluctuation in interest rates which will affect the day-to-day pricing of your bond.

There is an inverse relationship between interest rates and the value of a bond:

If interest rates go up, bond prices go down.
If interest rates go down, bonds go up in price.
Bonds move in the opposite direction to interest rates.

Think of a teeter-totter in order to understand this basic bond concept.

A rising interest rate trend is generally bad news if you are holding a bond or bond portfolio. So, if you're holding a bond that's paying 5% and interest rates go up to 10% well, this means you are stuck with a bond that's only paying 5%. Who’s going to buy your 5% bond if rates are now 10%? Not anyone who knows how to count!

If you had to sell the bond well before maturity, you would have to sell it at a lower price than what you paid for it in order to compensate the buyer for the lower interest rate. There are fancy computer programs to figure out how much you would have to drop the price of your bond in order to give the buyer the equivalent yield of 10%
 
Because bonds trade like stocks and are priced daily, this price adjustment goes on constantly. Please note that bonds – even Government of Canada bonds can change in price significantly. In 1982, a long term Canada bond dropped about 50% in value due to the soaring interest rates at the time.

So indeed yes, you can lose your shirt on a presumably “safe” investment.

Although I am able to offer my clients Canada bonds and provincial bonds, please see me for specific advice regarding your current investment situation.