With the advent of mutual and segregated funds it has become exceedingly rare to see regular individual investors buying bonds as well as many other traditional investment vehicles. After all, why take the risk of creating your own portfolio when you can let somebody who does it professionally do it for you? While it may be highly unlikely that most of us will ever buy individual bonds, we believe it is still useful to understand how this type of securities works. This will certainly help you make informed decisions when you invest in mutual funds, especially those with large bond components. In simple terms, a bond is a debt instrument or a document certifying that somebody owes you money.

Bonds can be issued by governments of various levels, credit institutions or companies. A government may need to borrow money to finance its public projects. A company may need cash to finance its ongoing operating expenses or fund a major acquisition. When a traditional bank loan is not available or has unacceptable terms, an entity has an option to issue bonds. There are multiple types of bonds which we will not be able to cover here today. Traditional bonds pay interest to the holder twice a year. This interest payment is called a coupon because originally bonds had detachable coupons which a bond holder would tear out and give to the issuer in exchange for cash.

Of course, today all transactions are made electronically and you can hardly ever see an actual paper bond. The interest rate can be either fixed or variable. For example, it may be linked to an index such as LIBOR. At the end of the term (maturity date) the issuer is obligated to pay the face value, or the originally invested amount, back to the bond holder. Another major type of bonds is a zero coupon bond. This type doesn’t have regular interest (coupon) payments. Instead, the bond is sold at a discount, or below the face value. The holder receives income at the end of the term when the bond is redeemed at face value.

There are many other types of bonds, which we will cover in the future. One thing to remember is that bond income, whether in a form of coupon payments or gain on redemption of zero coupon bonds, is always treated as interest income for tax purposes. This means that this income is 100% taxable, unlike capital gains which are taxable at a 50% inclusion rate or dividend income which also enjoys preferential tax treatment.

Therefore, bonds will work better for investors in lower income tax brackets. The major benefit of bonds is predictable, stable income. This is why they are used widely in mutual funds and custom-built portfolios, which enables fund managers to utilize the dollar cost averaging concept. This is also the reason why bonds are used extensively in portfolios designed to generate retirement income. Another benefit is that bonds are often secured by the assets of the issuer. And even when they are not, bond holders have much better chances of recovering their investments in the case of insolvency of the issuer, as compared to stock holders. Therefore, bonds are generally considered a safer investment vehicle.

Nikolay Sisan is a Certified Financial Planner and freelance writer in Vancouver.