CuVantis Education Series
The Basics of Bonds – What is a Bond and how do they work?
A bond is nothing more than a loan. When federal, state, or local governments or corporations want to borrow money to finance a project, they may issue bonds as a way to raise the money for that project. The bond buyer lends their money to the issuer by purchasing the bonds, and the bond issuer repays those loans (i.e. – the bonds) from the revenue that the completed project generates. Like any loan, a bond carries a specific interest rate and payment schedule that the issuer will pay to the bond holder. Unlike traditional loans, most bonds pay only interest over the term of the loan, with a balloon payment return of principal at the end of the loan, known as the bond maturity date. Because investors are able to loan their money to borrowers directly through the purchase of bonds, bonds often pay a higher interest rate than traditional savings or money markets. The promise of repayment typically makes bonds less risky than stock investments, but certain risks remain.
What are the risks associated with bonds?
There are several risks associated with bonds including reinvestment risk, liquidity risk and inflation risk, but we will cover just the two most common risks here. The first is credit risk, also known as default risk. Credit/default risk is the risk that the bond issuer will not be able to repay the loan or make the promised interest payments. Just as you and I need to “qualify” for a loan, bond issuers must also qualify for a credit rating. Issuers are rated from AAA to D based on their perceived ability to repay the loan and make all interest payments. The higher the rating the better the perceived ability the issuer has to repay the loan and make all the interest payments.
The second major risk associated with bonds is interest-rate risk. Since many bonds are issued for long time frames (up to 30 years) there is a risk that the bond buyer (the person who lent their money when purchasing the bond) may need their money back before the term of the bond expires. When this happens, the bond holder must seek a buyer in the secondary market. If interest rates have changed since the bond was issued, a secondary buyer may not be willing to pay the full face value for the bond. For example, if a bond holder owns a $1,000 bond paying 3%, but new bonds are offering 4%, the bond holder may have to discount the price of their bond to entice buyers to purchase their bond instead of a new one. This fluctuation of bond prices due to changes in interest rates is known as interest rate risk.
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The information presented here is for educational purposes only and should not be considered financial, tax or investment advice. Please consult a qualified professional.