- What they are: Debt securities in which you lend money to an issuer (such as a corporation or government) in exchange for interest payments and the future repayment of the bond’s face value.
- Pros: Certain bonds are risk-free (many are low-risk); predictable income; better returns compared with other short-term investments; certain bonds are tax exempt.
- Cons: Potential for default; selling before maturity can result in a loss.
- How to invest: Over-the-counter (OTC) markets including securities firms, banks, brokers and dealers. Some corporate bonds are listed on the New York Stock Exchange. U.S. government bonds can be purchased through a program called Treasury Direct (www.treasurydirect.gov).
A bond is an IOU issued by a corporation or government in order to finance projects or activities. When you buy a bond, you are extending a loan to the bond issuer for a particular period of time. In exchange for the loan, the issuer agrees to pay you a specified interest rate (the coupon rate) at regular intervals until the bond matures. In general, the higher the interest rate, the higher the risk for a bond. When the bond matures, the issuer repays the loan and you receive the full face value (or par value) of the bond.
As an example, assume you buy a bond that has a face value of $1,000, a coupon of 5%, and a maturity of 10 years. You will receive a total of $50 of interest each year for the next 10 years ($1,000 * 5%). When the bond matures in 10 years, you will be paid the bond’s face value; or $1,000 in this example.
As an alternative, you could sell the bond to another investor before the bond matures. If interest rates are more favorable now than when you bought the bond, you may take a loss and have to sell at a discount. If interest rates are lower, however, you may be able to sell the bond at a premium (since your higher-interest bond is more attractive). The price for the bond in the previous example (with a face value of $1,000, a 5% coupon, and a 10-year maturity) would decrease if bond rates rose to 6% or increase if bond rates fell to 4%. You would still, however, earn the 5% coupon and receive full face value if you decided to hold onto the bond until it matures.
Bonds expose investors to several types of risk, including default, prepayment and interest rate risk.
The possibility that a bond issuer will not be able to make interest or principal payments when they are due is known as default risk. While many are considered no- or low-risk (such as short-term U.S. government debt securities), certain bonds, including corporate bonds, are subject to varying degrees of default risk. Bond rating agencies, including Fitch, Moody’s and Standard & Poor’s, publish evaluations of the credit quality and default risk for many corporate bonds.
The possibility that a bond issue will be paid off earlier than expected is known as prepayment risk. This often occurs through a call provision. Many firms embed a call feature that allows them to redeem, or call, the bond before its maturity date at a specified call price. This feature provides flexibility to retire the bond early if, for example, interest rates decline. In general, the higher a bond’s interest rate in relation to current rates, the greater the risk of prepayment. If prepayment occurs, the principal is returned early and any remaining future interest payments will not be made. As a result, investors may be forced to reinvest funds in lower-interest rate bonds.
Interest Rate Risk
Interest rate risk is the possibility that interest rates will be different than expected. If interest rates decline significantly, you face the possibility of prepayment as firms exercise call features. If interest rates rise, you risk holding a bond with below-market rates. The longer the time to maturity, the higher the interest rate risk since it is difficult to predict rates farther into the future.
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