What is a Bond? Part 1

A Bond is one of the most basic types of investments. Investments can be broadly categorized into two main types: debt and equity (aka lending and owning).  A bond is the most widely used instrument for debt (lending) type investments and is part of the "fixed-income" asset class (named because these investments are expected to produce a (hopefully) stable and fixed level of income for the duration of the investment).

BondCertificate.jpgYou may be surprised to know that the Bond Market is roughly 21 times the size of the Stock Market in Canada - so while a lot of the glamour goes to stocks – more money is in bonds!

A company or government issues a bond when it needs money. Let’s say a company needs to buy some new equipment that will cost $10 million.  It may issue $10 million worth of bonds and promise to pay 6% interest on the bonds for 10 years, and after that time repay the $10 million. The company is therefore going to pay $16 million in total ($10 million + $600,000 interest per year for 10 years) to the bond-holders over the 10 years in exchange for using $10 million of their money NOW. BUT the company expects that it is going to generate $20 million in revenue over those 10 years because of that new equipment.  So after paying back the bond-holders, the company has made a $4 million profit on this transaction and the investors have earned 6% interest on their money.  This is the general mechanism in which a bond works.

Governments use bonds as a means of spreading out the costs of spending over many years.  For example, if a province thinks it needs a new bridge for one of its highways, and estimates that the useful lifespan of that bridge is 10 years – then it would issue a 10 year bond.  The theory is that while the bridge would be of benefit to 10 years’ worth of taxpayers (some leave the province and some are new to the province during those 10 years), it would be unfair to send the bill to only the current years’ tax-payers.  By issuing a 10 year bond, the cost is spread out over the 10 years.  In addition, the bond acts like a loan by the government: if the bridge were to cost $100 million and it issued a 10 year bond at 5% – it would take $15 million out of the annual budget over 10 years, versus $100 million in one year. ($5 million in interest every year plus $10 million towards the eventual repayment every year.)

The other thing that characterizes a bond is that the bond is secured by the assets purchased with the funds raised by issuing the bond. So in the case of the company which bought $10 million in equipment – if the company went under, the bond-holders would own the equipment.  A trustee would be appointed to liquidate the equipment for cash and give what money it could salvage back to the bond-holders.  This sounds great in practice but the equipment will have depreciated and may be hard to sell!  In which case it could be some time before the bond-holders get their money back (and they probably wouldn’t get it all)!

Because they are secured by real assets, bonds are considered less risky than stocks in general. Bonds are rated by what are known as "debt rating agencies" for their "credit-worthiness".  Two well known debt rating agencies are Standard and Poor’s and Dominion Bond Rating Service.  They will rate bonds with grades such as AAA, AA, A, BBB, BB, B, etc. BBB and above are known as "investment grade".  BB and below are known as "junk bonds".  These scales provide a relative reference of the chance of default of the bond issue.  Government of Canada bonds are AAA rated.

 




Preet Banerjee
Preet Banerjee
...is an independent consultant to the financial services industry and a personal finance commentator. You can learn more about Preet at his personal website and you can click here to follow him on Twitter.
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