Three types of bonds
Bonds are a hot topic these days. Bonds are not only popular when markets go through significant corrections but it’s tough not to be intrgiued with this conservative asset class when you look at the returns of bonds compared to stock over the past 10 years.
A significant reason for the strong consistent returns in the bond market over the past 10 years is the interest rate environment. Interest rates have not increased in the last 10 years. In fact they have continued to fall over the past 10 years, which helps bond prices. Some people argue that with the increased risk of rising interest rates, bonds have become risky and the past performance you see is not sustainable. I don’t disagree but I also don’t think you should necessarily speculate on the movement of interest rates and sell off all your bonds.
Related article: The basics of bonds
Bonds are an asset class that arguably should be in everyone’s portfolio and not all bonds are the same. Here are three distinct types of bonds:
Government bonds are the most common type of bond and are issues by different levels of government. There are Federal Government Bonds, Provincial bonds and municipal bonds.
Because these bonds are issued by the government, they are considered the safest type of bond. Government bonds are ‘safe’ because the likelihood of default is small.
Corporate bonds are the same as government bonds except that companies issue them instead of governments. Companies can issue bonds just as it can issue stocks. Corporate bonds are a popular way for companies to raise capital. Instead of borrowing from the banks, Bonds are a way of borrowing from investors.
Corporate bonds are considered higher risk than government bonds because there is a greater chance they will default on their debt. As a result interest rates on corporate bonds are almost always higher than the rates on government bonds.
For more information on Corporate Bonds: Understanding Corporate and High Yield Bonds
Real Return Bonds
Real Return Bonds (RRB) are very unique because they offer inflation protection that ordinary bonds cannot provide. Similar to government and corporate bonds, Real Return Bonds pay out a coupon but in addition to the coupon, there is an additional bonus as there is an incremental payment based on the level of inflation (CPI).
Many people criticize bonds and other fixed income investments as vehicles that do not do a good job fighting inflation because of low interest rates and inefficient taxation.
This is not true for real return bonds because they are an inflation hedge. Because of the additional inflation premium for real return bonds, the returns can go up as inflation goes up.
For more information on Real Return Bonds: Understanding Real Return Bonds
Which bond is best?
When buying bonds, there is no such thing as best. Different bonds work better for different situations, different investors and for different needs. The most prudent thing to do is diversify your bond holding just like you would diversify your equity holdings. Holding some of each protect you from holding the wrong type of bond at the wrong time.
Related Article: Three ways to buy bonds