Canto 2.2

Income

This category of investments has a higher risk of changes in value than the cash category, but also tends to have higher dividend payments. Income securities are usually called bonds. They can be issued by governments at all levels, or by companies.

If you buy a bond when it is originally issued, you are lending your money (the face value of the bond) to the government or company that issued it. They agree to pay you interest on a regular basis. The interest is called the coupon, because back when bonds were pieces of paper you kept in a safe deposit box, you used to actually clip the coupons off and redeem them for money. At the end of the term of the bond, the holder of the bond can redeem it for the face value. The amount of interest the issuer has to offer is related to how risky investors think they are. There are several rating services that study governments and companies and attach ratings to them, to help issuers and investors decide how much interest is appropriate for new bond issues. These rating services are trying to figure out what the chances are that the entity might get into financial trouble and be unable to pay the interest, or worse, be unable to pay the face value back at the end. This is called credit risk or default risk.

Usually once a bond has been issued, it can be resold on the bond market. Sometimes it can be sold for more than the face value and sometimes for less. This depends mostly on what interest rates have done since the bond was issued. For example, if the bond you hold has an interest rate of 5%, but new bonds from the same institution are now paying 6%, people are not going to be willing to buy your bond for its original face value. The amount they'll offer you is quite mathematical - it's the fraction of the face value that will make the effective interest rate for the remainder of the term equal to 6% instead of 5%. Similarly, if interest rates have dropped to 4%, they'll be willing to offer you more. This is called interest rate risk. Interest rate risk diminishes as you get close to the end of the bond's term, because soon it is going to pay back its face value. Another reason why your bond might be worth more or less than its face value on the bond market is because the rating services changed the credit rating of the government or company since you bought it.

You can buy bonds directly through a broker, but in the U.S. only about 10% of bonds are owned by individual households. I'm not sure what the percentage is in Canada. Anyway, most people buy bonds through a bond fund - they buy shares in a fund that owns lots of different bonds. That way your nest egg is in more baskets. Here are some kinds of bonds you might buy, either directly or as part of a fund:

If you are saving for a long-term objective - something you'll need the money for in five years or more - you should consider including investments in this category. Conventional wisdom (particularly American conventional wisdom) would advise that the longer it is until you need the money, the more you should have in stocks and the less you should have in bonds. In Canada, the advantage stocks have over bonds has been a lot smaller. From 1980 to 2012, earnings from stocks were just a fraction of a percent better in an average year than earnings from bonds. The returns from the bonds were also a lot steadier. I think that means that a Canadian investor should be comfortable including more bonds in their portfolio than a US investor might.


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Last Updated: 6 August 2014
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