Investing with fixed income

Fixed income securities appeal to investors for several reasons:

Diversification 

By diversifying your portfolio with fixed income securities, you can potentially reduce your investment risk and potentially increase your returns over time.

Safety

Fixed income securities may provide a steady stream of income and an issuer-guaranteed payback price if held to maturity. The safety of a fixed income security is reflected in the credit rating of the issuer; an issuer with a higher rating is judged by ratings agencies to have a better financial ability to make interest payments and repay the investment at maturity. Some debt ranks before equity within the capital structure in the event of liquidation or bankruptcy, providing fixed income investors with additional security. 

Certainty

High quality fixed income securities can provide a series of predictable cash flows over a period of time with lower risk to the invested capital than other types of investments. This feature is essential for budgeting and long-term planning. 

Choice

The multitude of fixed income securities available today provides investors with an array of product to choose from.

The real rate of return a bond offers is the stated return (yield) of the bond less inflation. If inflation rises, the purchasing power of the investor’s investment at maturity declines. This decline in value causes the current price of the bond to fall. If inflation declines over the holding period of the bond, the reverse is true and the value of the bond increases. In this instance, the purchasing power increases when it matures, which is reflected by higher current prices. Inflation cycles are long-developing, and it is more important to follow long-term trends rather than near-term fluctuations. 

For long maturity bonds, a major component in their valuations is the market’s collective expectations for future inflation. Inflation has been a focal point for central banks around the world since the 1980s. 

When held to maturity, high quality issues are generally considered conservative investments. Yet, like any investment, fixed income securities are subject to certain risks, including price fluctuation. This type of risk arises when you sell your fixed income investment prior to the maturity date. However, doing so can also work to your advantage. 

Bond prices and interest rates generally have an inverse relationship: when interest rates rise, prices on existing bonds tend to fall, and when rates fall, bond prices tend to rise. So, if you sell a fixed income investment before the maturity date and interest rates have risen since your original purchase, you may receive less than your original investment. Then again, if interest rates have fallen since that time, you may profit from the sale.  

The broad and growing appeal of fixed income investments has caused an explosion in the type and range of products available. Here are some of the more popular forms of debt available in the bond market: 

Government of Canada Bonds

Government of Canada Bonds are secured by the full faith, credit and taxing power of the Canadian government. The market for these securities is enormous, with billions of dollars exchanging hands daily. Because of their high quality and large market, Government of Canada Bonds also serve as the benchmark for all other Canadian fixed income securities. This means that all other fixed income securities are effectively priced relative to them. The higher an issue’s credit worthiness, the lower the yield relative to other bonds of the same maturity. Therefore, the difference in yield between a provincial bond and a federal government bond reflects the higher credit worthiness of the Government of Canada. Similarly, the credit worthiness of a province is typically higher than that of a corporation, so the yield of a provincial bond is typically lower than that of a corporate bond.

Provincial, municipal and agency bonds 

Just as the federal government has the need to offer fixed income securities to fund deficits that provide for public works and social welfare expenditures, so too do provinces, municipalities and various government agencies. Provinces issue Treasury Bills (T-Bills), notes and bonds. Instead of being federally guaranteed, these securities are often guaranteed by a province or territory. Because they are slightly less liquid, they generally provide higher yields than federal bonds. These higher yields also reflect the fact that the creditworthiness of a province or territory is somewhat lower than that of the federal government. Most municipalities and provincial government agencies issue bonds on the open market. These bonds typically provide semi-annual interest payments and the return of principal at maturity.

Money market instruments 

Money market instruments are typically used by investors seeking a short-term investment. The money market brings together borrowers and lenders of large sums of money for short periods of time. Aside from Government of Canada T-Bills, the 2 most common forms of money market instruments are Banker’s Acceptance (BA) and Commercial Paper. 

A BA is a short-term credit investment created by a corporation and guaranteed by a bank to make payment. BAs are offered at a discount from face value and pay accrued interest at maturity — just like a T-Bill. Yields on BAs tend to be slightly higher than federal or provincial T-Bills, reflecting the difference in creditworthiness between these corporate issuers and their government counterparts. Most BAs issued by major banks are rated as high as R1-High by DBRS Morningstar, and have terms to maturity ranging from 1 to 365 days, with the most liquid offerings set at 1-, 2-, 3-, 6- and 12-month terms. 

Similar to a BA is a Bearer Deposit Note (BDN). A BDN is a promissory note issued by a bank on a discounted basis. Terms on BDNs range from 1 to 365 days. As a direct obligation of the bank, BDNs are issued in bearer form at a discount and mature at par. BAs and BDNs offer numerous maturity terms, along with liquidity through an active secondary market. 

Commercial Paper investments are short-term, unsecured promissory notes issued by major corporations. Like T-Bills and BAs, Commercial Paper is sold at a discount and pays accrued interest at maturity. Commercial Paper is backed only by the creditworthiness of the issuer and generally provides the highest yield of any money market security. Issues range in rating from top investment grade quality down to the equivalent of junk bond status. Terms to maturity range from 1 to 365 days with most liquid offerings at 1-, 2- and 3-month terms. 

Corporate bonds and debentures 

Corporate bonds and debentures have earned a large place in the Canadian fixed income market. Because they offer a higher rate of interest than similar federal, provincial or municipal securities, they are an attractive option for investors willing to assume issuer credit risk and potential call features in return for higher yields. A corporate bond is secured by the pledge of specific assets; a corporate debenture is backed solely by the reputation and credit worthiness of the issuer.

Most corporate debt issues available through CIBC Investor’s Edge are unsecured debentures and are backed by the general credit of the issuer. Limited secured issues are also available, albeit at possibly lower yields. Like government securities, corporate debentures are available in a broad range of maturities and generally pay interest semi-annually. Many investors will recognize corporate debentures issued by well-known telecommunication companies, industrials, banks and other corporations. With such a wide selection available, independent credit rating agencies provide their opinions to assess the safety of individual issuers. 

Stripped bonds

Stripped bonds, also known as strips, are a popular retirement investment in the Canadian fixed income market and represent the ownership of a future payment. They are created when an investment dealer, such as CIBC World Markets, separates the interest-bearing coupons from the principal of a bond. Both of these elements may then be sold independently at a discount, allowing you to obtain quality and issuer-guaranteed returns for a modest investment. 

No periodic interest payments are made on stripped bonds. Instead, these securities are sold at discounts and compound to their maturity value. The purchaser of a strip knows the future value of the investment, so the rate of return to maturity is also predetermined. And because there are no periodic interest payments, the investor avoids re-investment risk. 

Because these strips represent the semi-annual interest payments of a conventional bond, a wide array of maturities is available. This variety of strip maturities provides an advantage when structuring a retirement portfolio, planning for a child’s education or hedging against interest rate fluctuations. Many investors choose to hold their strip bonds in a registered account due to the declining real returns on these investments when exposed to the combination of taxation and inflation.

Foreign bonds 

You should be aware of the differences that exist when investing in foreign bonds — different markets, types of yield quotes and currencies, for example. Some research on your own part is necessary and product is always subject to availability.

With any investment, what you get to keep after taxes is more important than what you earn. Canada Revenue Agency has very specific rules governing the tax treatment of the interest paid to you on your fixed income investments. To get a better understanding of the taxation of investment income, review the following report: A portfolio less taxing: Understanding the taxation of investment income (PDF, 190 KB) Opens in a new window..