What they Are When governments need to borrow they issue bonds in various denominations or face values. The face value is returned to you on the bond's future maturity date and you get paid interest in the interim.
How they Work Bonds come with face values of $1,000 or $10,000, and maturities of anywhere from one to 30 years. The interest rate the bond pays you - called the coupon -- is a fixed percentage of the face value. A $1,000 bond with a 10% coupon will pay you $100 interest per year, usually in two semi- annual $50 payments. In most cases, you won't pay face value for a bond. You will either buy it at a discount or premium to face value. If you pay less than face value, you will make a profit when the bond matures at full face value. When added to the interest you will have received, this profit pushes up your return. This mix of interest and capital gain or loss is the bond's yield. An attraction with bonds is that you don't have to wait until maturity to earn your full return. You can sell them in the bond market before they mature - and hopefully profit doing so. Whether you profit will mostly depend on what has happened to general interest rates since you bought the bond. If rates have come down, you will likely be able to sell the bond for more than you paid. If they've risen, however, you'll probably lose on the sale. Say you pay face value for a $1,000, 10-year Government of Canada bond paying 10%. Two years later, you decide to sell when interest rates have dropped and similar bonds are yielding 8%. Instead of selling your bond for $1,000, you can sell it for more because it's 10% coupon is attractive. So you sell the bond for $1,085, giving you an $85 profit that pushes up your return to 14.25%. Eight years later, the person who bought the bond will get back its $1,000 face value, leaving a loss of $85. Spread out over the bond's remaining eight years, that loss reduces the buyer's return to about 8%. Other factors besides interest rates can affect bond prices, such as the issuer's credit rating, the term to maturity, and the bond's coupon rate.
The Risks Rising inflation is a major risk to bonds because it pushes up interest rates. And if interest rates go up, bond prices drop. If you buy a bond and then have to sell when interest rates have gone up, you will realize a lower overall return on your investment. If you hold the bond until it matures, you might not keep ahead of inflation. Another risk is called re-investment risk. You might be satisfied with the interest income you're earning on a bond now, but when it matures in 10 years things might be different. You might find that the yields on bonds are too low to meet your income needs. This is a concern for people in retirement. You can counteract some of these risks buy buying bonds of staggered maturities, say 5, 10 and 15 years. When each of the bonds matures you can reinvest the money at the prevailing long-term rates. A slight risk with bonds is that the government that issued it won't be able to pay interest or repay the face value. The risk is slight, but it should be taken into account, especially if you're buying a long- term bond of 20 or more years.
The Rewards Conservative investors who want to earn income on their investments can buy government bonds and hold them to maturity. The returns on government bonds are generally better than for GICs and CSBs. More aggressive investors buy longer term bonds if they think interest rates are going to fall. If this happens, they can sell their bonds at a profit. Speculators buy bonds of issuers that are in financial difficulty or who are in default. They get the bonds cheap and hope to earn substantial profits if the issuer recovers and pays back interest owing and the bonds' face value. The risk, of course, is that they will lose all their money if the issuer doesn't recover.