Bondholder: Definition, Risks and Rewards, Taxes

What Is a Bondholder?

A bondholder is an investor or the owner of debt securities that are typically issued by corporations and governments. Bondholders are essentially lending money to the bond issuers. In return, bond investors receive their principal—initial investment—back when the bonds mature. For most bonds, the bondholder also receives periodic interest payments.

Key Takeaways

  • A bondholder is an investor who acquires bonds issued by an entity such as a corporation or government body.
  • Bondholders essentially become creditors to the issuer, and so bondholders enjoy certain protections and priority over stock (equity) holders.
  • The holders of bonds receive their initial principal back when the bonds mature in addition to periodic interest (coupon) payments for most bonds.
  • Bondholders may additionally profit if the particular bonds that they own increase in value, which can then be sold on the secondary market.

Bondholders Explained

Investors may purchase bonds directly from the issuing entity. For example, Treasury bonds can be bought from the U.S. Treasury during auctions of new issues. Bond investors can also purchase previously-issued bonds on the secondary market through a broker or financial institution.

Bonds are typically considered safer investments than stocks because bondholders have a higher claim on the issuing company's assets in the event of bankruptcy. In other words, if the company must sell or liquidate its assets, any proceeds will go to bondholders before common stockholders.


Introduction To Bond Investing

A Brief Primer on Bond Specifics

When investing in bonds, there are several vital areas that the bondholder must understand before investing. Unlike stocks, bonds do not offer ownership participation in a company through a return of profits or voting rights. Instead, they represent the issuer's loan obligations and the likelihood of repayment, and other factors influence their pricing.

Interest Rate

The coupon rate is the rate of interest that the company or government will pay the bondholder. The interest rate can be either fixed or floating. A floating rate might be tied to a benchmark such as the yield of the 10-year Treasury bond.

Some bonds don't pay interest to investors. Instead, they sell at a lower price than their face value or at a discount. A zero-coupon bond, for example, doesn't pay coupon interest but trades at a deep discount to the face value, rendering its profit at maturity when the bond returns its full-face value. For example, a $1,000 discounted bond might sell in the market for $950, and upon maturity, the investor receives the $1,000 face value for a $50 profit.

Maturity Date

The date of maturity is when the company must pay back the principal—initial investment—to bondholders. Most government securities pay back the principal at maturity. However, the corporations that issue bonds have a few options for how they can repay.

The most common form of repayment is called a redemption out of capital. Here, the issuing company makes a lump sum payment on the date of maturity. A second option is called a debenture redemption reserve. With this method, the issuing company returns specific amounts each year until the debenture is repaid on the date of maturity.

Some bonds are callable securities. A callable bond—also known as a redeemable bond—is one that the issuer may redeem at a date before the stated maturity. If called the issuer will return the investor's principal early, ending all future coupon payments.

Credit Ratings

The issuer's credit rating and ultimately the bond's credit rating impacts the interest rate that investors will receive. Credit-rating agencies measure the creditworthiness of corporate and government bonds to provide investors with an overview of the risks involved in investing in that particular bond as opposed to investing in similar products.

Credit rating agencies typically assign letter grades to indicate these ratings. Standard & Poor’s, for instance, has a credit rating scale ranging from excellent at AAA to C and D for securities that carry higher credit risk. A debt instrument with a rating below BB is considered to be a speculative-grade or a junk bond, which means the bond's issuer is more likely to default on loans.

Bondholders Earn Income

Bondholders earn income in two primary ways. First, most bonds return regular interest—coupon rate—payments that are usually paid semi-annually. However, depending on the structure of the bond it may pay yearly, quarterly, or even monthly coupons. For example, if a bond pays a 4% interest rate, called a coupon rate, and has a $1,000 face value, the investor will be paid $40 per year or $20 semiannually until maturity. The bondholder receives their full principal back at bond maturity ($1,000 x 0.04 = $40 / 2 = $20).

The second way a bondholder can earn income from the holding is by selling the bond on the secondary market. If a bondholder sells the bond before maturity, there's the potential for a gain on the sale. Like other securities, bonds can increase in value, but several factors come into play with bond appreciation.

For example, let's say an investor paid $1,000 for a bond with a $1,000 face value. If the bondholder sells the bond before maturity in the secondary market and the bond may fetch $1,050, thereby earning $50 on the sale. Of course, the bondholder could lose if the bond decreases in value from the original purchase price.

Bondholders and Taxes

Besides the upsides of regular passive income and the return of 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.

Rewards for Bondholders

The rewards available to bondholders include a relatively safe investment product. They receive regular interest payments and a return of their invested principal on maturity. Also, in some cases, the interest is not subject to taxes. However, with its upside bondholding also carries its share of risks.

  • Bondholders can earn a fixed income with regular interest—or coupon—payments.

  • Bondholders have the benefits of a safe, risk-free investment with U.S. Treasurys.

  • In case of company bankruptcy, bondholders receive payment before common stock shareholders.

  • Some municipal bonds provide tax-free interest payments.

  • Bondholders face interest rate risk when market rates are rising.

  • Credit risk and default risk can happen to corporate bonds tied to the issuer's financial viability.

  • Bondholders may face inflationary risk if inflation outpaces the coupon rate of the security they hold.

  • When market interest rates outpace the coupon rate, the face value of the bond on the secondary market may decrease.

Risks for Bondholders

The interest rate paid on a bond might not keep up with inflation. Inflationary risk is a measure of price increases throughout an economy. If prices rise by 3% and the bond pays a 2% coupon, the bondholder has a net loss in real terms. In other words, bondholders have inflation risk.

Bondholders also must deal with the potential of interest rate risk. Interest rate risk occurs when interest rates are rising. Most bonds have fixed-rate coupons, and as market rates rise, they may end up paying lower rates. As a result, a bondholder might earn a lower yield compared to the market in the rising-rate environment.

Being a bondholder is generally perceived as a low-risk endeavor because bonds guarantee consistent interest payments and the return of principal at maturity. However, a bond is only as safe as the underlying issuer. Bonds carry credit risk and default risk since they're tied to the issuer's financial viability. If a company struggles financially, investors are at risk of default on the bond. In other words, the bondholder might lose 100% of the principal invested should the underlying company file bankruptcy.

For example, holding corporate bonds typically yields higher returns than holding government bonds, but they come with higher risk. This yield difference 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 during upheaval can still carry a far greater risk of default than those issued by financially stable governments and corporations.

Bond investors must consider the risk-versus-reward of being a bondholder. Risk causes bond prices on the secondary market to fluctuate and deviate from the bond's face value. Potential bondholders may not be willing to pay $1,000 for a bond with a $1,000 face value if it's issued by a new company with little earnings history, or by a foreign government with an uncertain future.

As a result, the $1,000 bond may only sell for $800 or at a discount. However, the investor who purchases the bond is taking the risk that the issuer will not fold or default before the investment's maturity. In return, the bondholder has the potential of a 20% gain at maturity.

Real-World Examples of Investing as a Bondholder

Potential bondholders can invest in government bonds or corporate bonds. Below is an example of each with the benefits and risks.

Government Bonds

A U.S. Treasury bond (T-bond) is issued by the U.S. government to raise money to finance projects or day-to-day operations. The U.S. Treasury Department issues bonds via auctions at various times throughout the year while existing bonds trade in the secondary market. Considered risk-free with the full faith and credit of the U.S. government backing them, T-bonds are a favorite investment for conservative investors. However, the risk-free feature has a drawback as T-bonds usually pay a lower interest rate than corporate bonds.

Treasury bonds are long-term bonds—maturities between 10 to 30 years—providing semiannual interest payments, and have $1,000 face values. The 30-year Treasury bond yield closed at 2.817% March 31, 2019, so the bondholder receives 2.817% yearly. At maturity, in 30 years, they receive the full invested principal back. T-bonds can sell on the secondary market before maturity.

Corporate Bonds

Bed Bath & Beyond Inc. (BBBY) has currently a discount bond as of April 05, 2019. The fixed bond—BBBY4144685—has a rate of 4.915 and matures in August 2034. As of April 05, 2019, the bond priced at $77.22 versus the $100 offering price at the original issue. The value of the bond fell as BBBY had financial difficulty for several years.

At times, the yield for the BBBY bond has risen to as much as 7% coupon reflecting the credit risk involved with the security. As a comparison, a 10-year Treasury yield runs around 2.45%. The BBBY offering is deeply discounted with a generous yield and a hardy serving of associated risks. Should the company file for bankruptcy, bondholders could face losing their entire principal.

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