In a previous video, I outlined that investing isn’t like gambling, if done right. Investors will earn a return on their money by offering it up to companies that can use it to earn profits. You can choose to buy either company stock (aka shares, or equity) or company bonds (aka debt, or fixed income).

But how does that actually work in practice, how exactly do you make money on investments?

How you earn a return on your investments will entirely depend on what you’re investing in. I’m going to stick to bonds, also known as debt or fixed income, for this video.
The easiest type of fixed income is a GIC, Guaranteed Investment Certificate. As the name suggests, these deposits are guaranteed, up to a certain amount. If you hold a GIC at a financial institution and it goes bust, you don’t risk losing your initial investment or interest if you’re under the limit. These are insured through Canada Deposit Insurance Corporation (CDIC). A GIC has a specified interest rate when you buy it. For example say you purchase a 5 year GIC with an interest rate of 2%. You’ll get a 2% guaranteed interest rate every year for those 5 years. After 5 years are up, you’ll get your initial investment back. There are multiple types of GIC’s. Some pay out the interest on a regular basis, monthly or yearly, others simply reinvest the interest each year and pay you all the interest when the GIC matures. Most GIC’s are locked-in or illiquid. If you need your money before the GIC matures, you may not be able to access it. If you can access it, you’ll likely have to forfeit any interest you’ve earned on it so far. There are cashable GIC’s which allow you to pull money out of the GIC with 30 or 90 days’ notice. Since these are more liquid, they pay a lower interest rate.

The second type of fixed income I’ll discuss are bonds. As you’ll remember, bonds are where you lend your money to a corporation or government and they agree to pay you a certain amount in interest every year for your money. After a specified period, the maturity date, the borrower will give you back your initial money. Say I have $10,000 to invest in a corporate bond. This $10,000 initial bond value is called the par value. In return for letting the company use my money, they will pay an annual interest rate of 4% twice a year. So every 6 months, I’ll get $200. This $200 is called a coupon payment. The term on this bond is 5 years, so after 5 years, I’ll get my initial $10,000 back, plus the final coupon payment of $200. The tax authorities call this type of income interest income. Sounds easy right?

Well it is easy… if you have your $10,000 available when a company is issuing bonds (in other words, going through the process of collecting a chunk of money from investors to invest in a project and setting out the borrowing terms of the bond – the interest rate, maturity date, and a potential host of other items not relevant to this discussion). But the fact is that companies don’t do this every time they need $10,000. They’ll issue a bunch of bonds and collect a large amount of money at once. This means that when you have your $10,000 ready to invest, you very well might not be buying a bond when the government or company first issues it. You’ll be buying it from other investors who bought it when it was initially issued.

This means that depending on what has happened in markets since the bond was issued, the price might have changed. Say the Province of Ontario issued that 4% bond in 2012. Since then, oil prices have dropped and interest rates in Canada have fallen. The Province of Ontario has issued a new bond that matures at the same time as the bond in 2012, but instead of paying 4%, it’s only paying 2.5% on it. If you could get your hands on the 4% bond, you’d be much better off, getting an extra 1.5% per year in interest! Well, not so fast. In order to compensate for this higher interest rate the markets increase the price of the bond, so that you’re in the exact same position return-wise if you bought the 4% coupon-paying bond or the 2.5% coupon-paying bond. The price of this bond might be something like $110, meaning that for every $100 worth of par value (what you’ll get back at maturity), you’d pay $110. A bond that matures at $10,000 would cost you $11,000, but you’re compensated for that $1,000 loss by getting a higher interest rate along the way. This type of bond is called a premium bond.

If on the other hand, interest rates rise, like they just did recently for the first time in seven years, you wouldn’t want to pay $10,000 for a bond that only pays 4%, when you could turn around and buy another bond for $10,000 that pays 5% instead! In order to encourage people to be indifferent between the two, the market drives down the price of the 4% bond. Maybe you only have to pay $9,500 for $10,000 worth of the 4% bond. You’ll still receive the same return, it will just come from a different proportion of interest and capital gains. You’ll get a lower interest payment on the bond on a regular basis, but when it matures, you’ll get an extra $500. This type of bond is called a discount bond. All things being equal, for investors that don’t have to worry about tax (i.e. those who invest in RRSP’s or TFSA’s), you should be indifferent between two bonds based on their interest rate, since they will be priced to give you the exact same return (in industry jargon: yield to maturity).

In summary, the golden rule of bonds is:

When interest rates rise, the price of the bond falls. When interest rates fall, bond prices rise. Remember those GIC’s? They don’t change in price like bonds because they are illiquid. If you could buy and sell GIC’s after you initially purchased them, they would act in the same way. In order to compensate you for their illiquidity, GIC’s offer a slightly higher return compared to short-term bonds.

I’ve focused on bonds for this video, but next time, I’ll talk about how exactly you earn a return on equities, so subscribe to my channel to be sure you don’t miss it.