When investors buy a bond, they are lending money to the entity that issues the bond. The bond is a promise to repay the face value of the bond (the amount loaned) with an additional specified interest rate within a specified period of time. The bond, therefore, may be called an "I.O.U."
SEE: Introduction To Bond Investing Video
The various types of bonds include U.S.government securities, municipals, mortgage and asset-backed, foreign bonds and corporate bonds.
Corporate bonds are issued by companies and are either publicly traded or private. Bond rating services such as Standard & Poor's, Moody's and Fitch, calculate the risk inherent in each bond issue - the chances of a default or failure to pay - and assign a series of letters to each issue signifying its risk factor.
Bond Ratings and Risk
Bonds rated triple-A (AAA) are the most reliable and the least risky; bonds rated triple B (BB) and below are the most risky. Bond ratings are calculated using many factors including financial stability, current debt and growth potential.
In a well-diversified investment portfolio, highly-rated corporate bonds of short-term, mid-term and long-term maturity (when the principal loan amount is scheduled for repayment) can help investors accumulate money for retirement, save for a college education for children, or to establish a cash reserve for emergencies, vacations or for other expenses.
SEE: Top 4 Strategies For Managing A Bond Portfolio
Buying (and Selling) Bonds
Some corporate bonds are traded on the over-the-counter (OTC) market and offer good liquidity - the ability to quickly and easily sell the bond for ready cash. This is important, especially if you plan on getting active with your bond portfolio. Investors may buy bonds from this market or buy the initial offering of the bond from the issuing company in the primary market. OTC bonds typically sell in $5,000 face values.
Primary market purchases may be made from brokerage firms, banks, bond traders and brokers, all of which take a commission (a fee based on a percentage of the sale price) for facilitating the sale. Bond prices are quoted as a percentage of the face value of the bond, based on $100. For example, if a bond is selling at 95, it means that the bond may be purchased for 95% of its face value; a $10,000 bond, therefore, would cost the investor $9,500.
Interest on bonds is usually paid every six months. On the highest rated bonds, these semi-annual payments are a reliable source of income. Bonds with the least risk pay lower rates of return. The higher risk bonds, in order to attract lenders (buyers), pay a higher return but are less reliable.
When bond prices decline, the interest rate increases because the bond costs less, but the interest rate remains the same as its initial offering. Conversely, when the price of a bond goes up, the effective yield declines. Long term bonds usually offer a higher interest rate because of the unpredictability of the future. A company's financial stability and profitability may change over the long term and not be the same as when it first issued its bonds. To offset this risk, bonds with long maturity dates pay a higher interest.
A callable or redeemable bond is a bond that may be redeemed by the issuing company before the maturity date. The downside for investors, if a high yield bond is called, is the loss of interest return for the years remaining in the life of the bond. Sometimes, however, a firm calling a bond will pay a cash premium to the bond holder.
SEE: Find The Right Bond At The Right Time
Bond prices are listed in many newspapers, including Barron's, Investor's Business Daily and The Wall Street Journal. The prices listed for bonds are for recent trades, usually for the previous day, so keep in mind that prices fluctuate and market conditions may change quickly. An alternative to investing in individual corporate bonds is to invest in a professionally managed bond fund or an index-pegged fund, which is a passive fund tied to the average price of a "basket" of bonds.
The Bottom Line
A well-diversified investment portfolio should hold a percentage of the total amount invested in highly-rated bonds of various maturities. Although no corporate bond is entirely risk free, and may sometimes even result at a loss because of changing market conditions, highly-rated corporate bonds could reasonably assure a steady income stream over the life of the bond.