Bonds are essentially loans from investors to entities such as governments or corporations. In exchange, the issuer pays periodic interest (coupon payments) and repays the principal (face value) at maturity. Bonds can vary by issuer (government, corporate, or foreign), term (maturity length), and credit risk (likelihood of default).
Key drivers of bond returns include term and credit risk. Longer-term bonds typically offer higher returns due to increased risk over time. Similarly, issuers with lower credit ratings offer higher coupon rates to compensate for the increased risk of default. Bond returns consist of two main components: interest income from coupon payments and price appreciation, which is influenced by market interest rates. Bond prices move inversely to interest rates—when rates rise, bond prices fall, and vice versa. This dynamic is essential for understanding how to time bond investments.
While bonds tend to be lower-risk than stocks, they are not immune to losses, particularly if sold before maturity or if interest rates rise. Additional risks include inflation risk, credit risk, and liquidity risk. Inflation can reduce the real value of the bond's fixed payments, while liquidity risk can make it challenging to sell bonds quickly without affecting the price. Bonds can still be affected by credit risk if the issuer is unable to meet its payment obligations.
Investors are attracted to bonds for several reasons, including predictable income, capital preservation, and diversification. Additionally, in the event of bankruptcy, bondholders are prioritized over stockholders for payouts, providing more security. For these reasons, bonds are considered a relatively stable component of a well-diversified portfolio.
Bonds can also provide protection against certain types of market volatility, behaving differently from equities during periods of economic uncertainty. As explained in our ‘Understanding Volatility’ blog, having a well-diversified portfolio can help investors ride out market fluctuations. High-quality government or investment-grade corporate bonds, for example, may hold or even increase in value when stock markets decline, as investors seek safer assets, and thus help to stabilize returns over time.
For greater diversification and liquidity, bond funds (mutual funds and ETFs) allow investors to hold a portfolio of bonds. Bond funds are professionally managed and typically offer more frequent income distributions. While funds can help mitigate individual security risk, the risks of the underlying bonds (like interest rate and inflation risk) are still relevant and it’s important to understand the makeup of the funds and how they fit into your overall portfolio.
If you would like to learn more about bonds and how their prices interact with changing interest rates, please check out our white paper, 'Guide on Bonds', which provides an in-depth look at these concepts.
The opinions expressed in this report are the opinions of the author and readers should not assume they reflect the opinions or recommendations of Richardson Wealth or its affiliates. Assumptions, opinions and estimates constitute the author's judgment as of the date of this material and are subject to change without notice. We do not warrant the completeness or accuracy of this material, and it should not be relied upon as such. Before acting on any recommendation, you should consider whether it is suitable for your particular circumstances and, if necessary, seek professional advice. Past performance is not indicative of future results. The comments contained herein are general in nature and are not intended to be, nor should be construed to be, legal or tax advice to any particular individual. Accordingly, individuals should consult their own legal or tax advisors for advice with respect to the tax consequences to them, having regard to their own particular circumstances. Richardson Wealth is a member of Canadian Investor Protection Fund. Richardson Wealth is a trademark by its respective owners used under license by Richardson Wealth.