Glossary of terms
Short-term bonds have a time to maturity of less than five years and tend to be less sensitive to changes in interest rates than longer-term bonds.
In a rising-interest-rate environment, short-term bonds tend to perform better than longer-term bonds; however, they still tend to be negatively affected by rising interest rates.
In a falling-interest-rate environment, short-term bonds tend to underperform longer-term bonds, but still tend to be positively affected by falling interest rates.
Short-term bonds are also associated with reduced credit risk, because there is less time for the issuer to default before the bonds mature. Short-term bonds are considered a relatively safe investment and tend to perform well when investors are looking for safe places to invest in times of economic or equity market downturns.
Government bonds include bonds issued by federal, provincial and municipal governments. Government bonds are backed by a government’s ability to collect taxes and print money in order to pay the coupons promised to their bondholders. A government bond issued by a developed country is generally considered to be a low-risk investment. Government bonds usually offer a low rate of return, due to their relative safety.
Select government bonds are designed to protect against inflation. Inflation can affect the real return for investors, and can even cause the real return to be negative, if inflation is higher than a bond’s yield. Real return bonds (RRBs) in Canada and Treasury Inflation-Protected Securities (TIPS) in the U.S. protect against inflation by benchmarking interest rates to inflation, but these types of securities have minimal opportunity for price appreciation.
Government bonds carry interest rate risk, because government bond prices are closely tied to interest rates. In rising-interest-rate environments, government bonds tend to underperform corporate and non-investment-grade bonds, because their value declines when interest rates rise. In falling-rate environments, government bond prices appreciate, and the bonds increase in value. Government bonds generally perform well during economic downturns, because interest rates typically fall during these periods.
Corporate bonds are debt securities issued by corporations.
Investment-grade corporate bonds
A corporate bond is referred to as an investment-grade corporate bond when it is issued by a corporation that is rated BBB or higher by an independent rating agency. Investment-grade corporate bonds typically offer slightly higher coupon rates than government bonds, because corporate bonds have a higher level of default risk. Corporate bonds generally have this higher risk of default because they are backed by a corporation’s ability generate revenue to repay debt, whereas governments that issue bonds have the ability to collect taxes to repay debt. The level of default risk varies depending on the corporation and is reflected in the total return being offered by different bonds.
Corporate bonds, like government bonds, generally pay a fixed coupon and are exposed to interest rate risk. They tend to underperform in rising-rate environments, when bond prices fall, and they outperform in falling-rate environments, when bond prices rise.
They also have more default risk than government bonds, because a company may perform poorly and may be unable to repay the loan. As a result of default risk, corporate bonds may have reduced returns, compared with government bonds, during periods of economic and market volatility as company fundamentals change. However, in times of economic growth and stability, corporate bonds generally outperform government bonds, due to their higher yields.
High-yield bonds are bonds that are rated below investment-grade (below BBB), due to a higher likelihood of default by the issuer, typically a corporation. High-yield bond yields are based on a spread above the yield for a government bond of the same maturity. These spreads tighten when the issuing company’s fundamentals improve, because strengthening fundamentals signal that the company is less likely to default, reducing the risk of permanent loss of capital associated with the issuer and causing bond prices to increase. High-yield bonds offer both attractive yields and the potential for capital gains.
High-yield bond values are more firmly tied to the fundamentals of the underlying corporate issuer than to interest rates. For this reason, as well as having higher coupon rates, high-yield bonds tend to perform better during rising-interest-rate environments than investment-grade bonds.
High-yield bonds have a higher risk of default and carry more liquidity risk than investment-grade bonds. They are also exposed to economic risk, because the risk of default increases when the corporate issuer experiences unstable or poor performance, which is more likely to occur during economic downturns. In periods of economic growth, high yield tends to perform well as company fundamentals improve.
High-yield bonds can result in equity-like returns with reduced volatility in periods of economic growth when corporate fundaments are rapidly improving. They also provide diversification to the fixed-income portion of a portfolio, because high-yield bond returns tend to have a low correlation with investment-grade bond returns.
Floating rate bonds (which can also include leveraged loans) are issued by a corporation and pay a variable coupon rate that adjusts to an underlying reference rate, such as the LIBOR, in addition to a fixed spread above the reference rate. The coupon is reset periodically over a predetermined time period, which reflects changes in the reference rate.
The result is that floating rate coupons tend to move in tandem with short-term interest rates, reducing the impact of rising interest rates on floating rate bonds.
However, in a falling-interest-rate environment, floating rate bond coupons are adjusted lower as interest rates fall, limiting the price appreciation bonds generally experience when interest rates fall.
Floating rate bonds can be investment-grade or non-investment-grade, depending on the credit quality of the issuer. Non-investment-grade floating rate bonds share characteristics with high-yield bonds, while investment-grade floating rate bonds share characteristics with investment-grade corporate bonds.
Floating rate bonds are generally secured by company assets and are higher in the capital structure than high-yield or even investment-grade bonds. In the event of default, bondholders have a claim on the specific company assets that have been used to back the floating rate bonds, providing an additional layer of protection for investors.
Fixed-income securities issued by governments or corporations in countries classified as an emerging market are considered emerging markets debt (EMD).
The potential for growth is an attractive feature of emerging markets debt, because the potential growth rate in developing countries may be significantly higher than in developed countries. EMD yields tend to be higher than their developed country counterparts, to compensate investors for taking on additional risks associated with investing in emerging markets.
Investing in emerging markets debt involves political, economic and currency risk. Emerging market countries tend to have a higher level of socioeconomic risk, with potential political instability and a risk of rapid inflation or deflation. Currency risk stems from currency devaluations and exchange rate fluctuations, which heighten volatility and lower yield returns.
EMD performs well in times of strong economic growth and stability in the issuing country. If there is a downturn in the economy or increased instability, EMD will underperform.
Investing in emerging markets debt can provide diversification to a fixed-income portfolio, providing exposure to different markets and countries, and limiting the impact of any one central bank’s decision to raise interest rates.
Global bonds are fixed-income securities issued by governments or companies in foreign countries. They provide investors with an opportunity to diversify their portfolios by gaining exposure to a variety of foreign markets and countries, limiting the impact of any one central bank’s decision to raise interest rates or a change in the economic outlook of any one single country.
Global bonds perform in the same manner as comparable Canadian bonds, but are affected by the economic state and central bank policies of the country in which they are issued.
Currency risk is a factor when investing in global bonds, because exchange rates will affect returns. Currency risk can be minimized by hedging foreign currency exposure, such as by investing in a currency neutral mutual fund. Global bonds are also subject to risks specific to the country in which they are issued.
Commissions, trailing commissions, management fees, brokerage fees and expenses may be associated with investments in mutual funds and ETFs. Please read the mutual fund or ETF’s prospectus, which contains detailed investment information, before investing. Mutual funds and ETFs are not guaranteed. Their values change frequently. Past performance may not be repeated.
In general the bond market is volatile, and fixed-income securities carry interest rate risk. As interest rates rise, bond prices usually fall, and vice versa. This effect is usually more pronounced for longer-term securities. Fixed-income securities also carry inflation, credit and default risks for both issuers and counterparties. Unlike individual bonds, most bond funds do not have a maturity date, so holding them until maturity to avoid losses caused by price volatility is not possible.
Foreign securities are subject to interest rate, currency exchange rate, economic and political risks, all of which are magnified in emerging markets.
Lower-quality bonds can be more volatile and have greater risk of default than higher-quality bonds.
The municipal market is volatile and can be significantly affected by adverse tax, legislative or political changes, and the financial condition of the issuers of municipal securities.
A fund can invest in securities that may have a leveraging effect (such as derivatives and forward-settling securities) that may increase market exposure, magnify investment risks and cause losses to be realized more quickly.
This information is for general knowledge only and should not be interpreted as tax advice or recommendations. Every individual’s situation is unique and should be reviewed by his or her own personal legal and tax consultants. The statements contained herein are based on information believed to be reliable and are provided for information purposes only. Where such information is based in whole or in part on information provided by third parties, we cannot guarantee that it is accurate, complete or current at all times. It does not provide investment, tax or legal advice, and is not an offer or solicitation to buy. Graphs and charts are used for illustrative purposes only and do not reflect future values or returns on investment of any fund or portfolio. Particular investment strategies should be evaluated according to an investor's investment objectives and tolerance for risk. Fidelity Investments Canada ULC and its affiliates and related entities are not liable for any errors or omissions in the information or for any loss or damage suffered.
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