Bonds explained

Bonds are a type of investment where the investor lends money to an entity (generally a company or government) in exchange for payment in full with interest.  Bond owners are called bondholders, and are not owners of the corporation, but are owed a debt by the company or government.  There are various types of bonds but generally bondholders are paid periodic interest payments known as coupon payments, and then re-paid the principle amount at the end of the bond term.  Bonds are also called fixed income investments because they provide generally fixed returns when held to maturity.

Why companies and governments sell bonds

Companies and governments borrow money by selling bonds to raise capital (money) to invest in a variety of projects.  For example, companies may use the capital to invest in research and development, and governments may use the capital to fund building projects.

How bonds work

Bondholders are compensated for lending money to companies and governments by receiving payment in full plus interesting.  Interest rates are usually fixed and may have coupon payments paid during the bond term (e.g., annually or semi-annually).

For example, an investor buys a $1,000 10 year bond with a 4% coupon (interest rate) paid annually.  The investor will receive $40 at the end of every year ($1,000 * 4%), and will receive the original principle $1,000 at the end of the tenth year.

How bonds are traded

Bonds can be purchased directly from governments or companies, but are frequently traded between investors on exchanges.  The value of bonds traded on exchanges depend upon the prices investors are willing the pay for a bond.  Bond prices fluctuate based on many factors such as prevailing interest rates for competing bonds and the credit rating of the entity.

Yield

The bond yield is the return the investor will receive for owning the bond.  At bond issue, the yield is equal to the coupon rate (the interest rate). Because bonds prices in the market fluctuate over time, the yield fluctuates as well.  Using the earlier example, if the $1,000 10 year bond with a 4% coupon is sold to another investor at a price of $1,200, the new yield becomes 3.3%.  This occurs because the coupon (4% of the original $1,000 = $40) is fixed and therefore $40 / $1,200 = 3.3%.

Callable bonds

Some bonds are callable which means the company or government can pay off the debt to the investor early without penalty.  Callable bonds give the borrower more control while non-callable bonds give investors more control.  For that reason, callable bonds have lower yields than non-callable bonds when all other factors are the same.

Bond credit ratings

Just like individuals have credit scores, bonds and the entities that issue them have credit ratings which are an assessment of the entity’s ability to repay the loan.  Investment grade bonds are lower risk than junk grade bonds.  The three primary bond credit rating agencies are Moody’s, S&P, and Fitch.

GradeMoody’sS&P
InvestmentAaaAAA
InvestmentAaAA
InvestmentAA
InvestmentBaaBBB
JunkBa, BBB, B
JunkCaa, Ca, CCCC
JunkD

Risks involved

The two primary risks involved in bond investing are credit / repayment risk and interest rate / bond value risk.

  • Credit / repayment risk – The risk that the entity is unable to pay the interest or repay the principal, and the investor loses money.
  • Bond value risk – The risk that the bond loses value on the open market (i.e., other investors are no longer willing to pay the original price for the bond that the investor paid).  Bond prices fluctuate for a variety of reasons such as interest rate changes buy central banks and changes to an entity’s credit ratings.  It’s important to note that bond value risk is only realized if the investor decides to sell the bond.  The investor does not lose money if the bond is held to maturity because the investor still receives the interest and principal payments.

Bonds are usually a key part of a well diversified portfolio and can be purchased directly or indirectly through other securities such as ETFs or mutual funds.

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