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Fixed income investments can be a great way to provide a floor for you investment portfolio and to preserve your capital. One popular way of investing in fixed income is through the bond market. The size of the bond market in Canada as of December 2014 was $2.4 trillion (face value) and to give some perspective the size of the TSX at that time was $2.511 trillion (market cap). Though the bond market is very substantial it doesn’t get nearly as much press as the stock market, and it remains a mystery to most people. Below is an explanation of some of the fundamental concepts about bonds as well as the risks.
When you are buying bonds you are buying debt or an IOU. Essentially you are lending money for a set period of time and in return you’ll receive regular interest payments until the bond matures. When the bond matures you will receive back the loan amount or face value of the bond.
Bonds can be issued by both the public and private sectors and in general the riskier the bond the higher the interest rate. Government bonds will have lower yields than even established corporations like the Toronto Dominion Bank, but Toronto Dominion Bank will have lower yields than “New Start-up Corp” which would be considered riskier. Furthermore, the longer the time period until the bond matures the higher the yield, all things remaining equal.
Lastly, interest rates will have a significant impact on bond prices. When interest rates rise bond prices will fall. This is because new bonds will be issued with higher yields and the lower interest bonds will become less valuable. Ultimately though if you hold the bond till maturity it would not matter and you would get back your original investment. This is unless the government or company goes belly up!