What is a 'Bondholder'
A bondholder is the owner of a government, municipal or corporate bond. Investors may purchase bonds directly from the issuing entity or on the secondary market if the original bondholder decides to sell prior to maturity. Bondholders are entitled to a return of principal when the bond matures and, with the exception of those who own zero-coupon bonds, periodic interest in the form of coupon payments.
BREAKING DOWN 'Bondholder'Bonds are typically considered safer investments than stock because bondholders have a higher claim on the issuing company's assets in the event of bankruptcy. This means if the company must liquidate everything to pay its debts, bondholders receive payment before shareholders. Of course, neither are paid before the company settles debts with banks, mortgage holders and other creditors.
Bondholder Risks and Rewards
Being a bondholder is generally perceived as low risk because bonds guarantee consistent interest payments and the return of principal at maturity. However, the true level of risk is dependent on the type of bond in question and the entity that issues it.
For example, holding corporate bonds typically yields higher returns than holding government bonds, but they come with greater risk. This is because it is less likely a government or municipality will file for bankruptcy and leave its bondholders unpaid. Of course, bonds issued by foreign countries with shakier economies or governments in the midst of upheaval can still carry far greater risk of default than those issued by financially stable American corporations.
It is these types of specific risk-versus-reward calculations that cause bond prices on the secondary market to fluctuate away from a bond's face value. Potential bondholders may not be willing to pay $1,000 for a $1,000 bond if it is issued by a new company that has not yet proven itself, or by a foreign government with an uncertain future. In this case, a $1,000 bond may only sell for $800, meaning the bondholder who purchases it is taking the risk the issuing entity will not fold, in exchange for the potential 25% gain at maturity.
Other Things to Consider
In addition to the risks associated with the issuing entity's financial standing, bonds are also subject to several other types of risk, including interest rate risk, reinvestment risk, inflation risk, credit/default risk, liquidity risk and rating downgrades. The degree of peril posed by any of these risk types varies from bond to bond based on issuance, maturity date and changes in the larger economy over time.
Besides the obvious upsides of regular passive income and the return of an investment at maturity, one big advantage of being a bondholder is the income from certain bonds may be exempt from income taxes. Municipal bonds, those issued by local or state governments, often pay interest that is not subject to taxation. However, to purchase a triple-tax-free bond that is exempt from state, local and federal taxes, you typically must live in the municipality in which the bond is issued.