Let's take a look at what bonds are and how they can help investors build diversified portfolios.
Bonds allow governments or corporations to borrow money from investors, and are typically issued at a set interest rate, also known as a coupon, which is paid over a specific period of time. Companies and governments issue bonds in order to fund new projects or pay expenses.
Bonds issued by governments typically pay lower interest than corporations. They are deemed safer because there's a lower risk they will be unable to pay back the loan. Returns on government bonds aren't typically tied to the stock market, but rather reflect the credit rating of a government or business, as well as inflation rates and the overall economic outlook.
For example, when inflation was high in the early 1980s, bond yields were also high. In September of 1981, the yield on a thirty-year Government of Canada bond was around eighteen per cent, while inflation that year averaged twelve point five per cent. At the beginning of 2017, the yield on a thirty-year Government of Canada bond was closer to two point three per cent.
Take the City of Parkstown for example. The city wants to build a new park, so it issues bonds to raise the money. Each bond has a face value of one thousand dollars, which the city promises to pay back in seven years, when the bond will mature. To encourage investors, Parkstown offers an interest rate of five per cent, or fifty dollars, which they'll receive regular payments of for seven years. At maturity, the investor will also get the face value of a thousand dollars back.
In the end, Parkstown got its park, and the investor got a steady stream of income. This income will come in the form of coupons, which the city funds through its ability to collect property tax from its residents.
Bonds can serve many purposes for investors. They can provide a predictable source of income, help preserve capital, and add attractive diversification benefits to their portfolio as they tend not to move in the same direction as other asset classes.
To learn more about how bonds can fit into your portfolio, contact your financial advisor or visit rbcgam.com.