What is a bond?
When a company or government entity needs money to help fund day-to-day operations or finance certain projects, they issue debt in the form of bonds. Investors who purchase bonds are essentially making a loan to the bond issuer. In exchange, the issuer pays the investor periodic interest payments.
How does investing in bonds work?
The bond issuer promises to pay the investor a specified rate of interest during the life of the bond and to repay the face value of the bond (typically $1,000) when it matures.
Why should I invest in bonds?
Bond ownership offers a host of potential benefits, including:
- Income: Most bonds pay interest every six months and offer a steady stream of income (except zero-coupon bonds).
- Safety of principal: Bondholders are first in line for repayment if the issuing corporation declares bankruptcy and liquidates assets (although that doesn’t guarantee they will get their money back).
- Tax savings: Certain bonds provide tax-free income.
- Diversification: Bonds are typically less volatile than most stocks. Adding bonds to a portfolio can help create more stability with less fluctuation in value than other, more aggressive investments.
Categories of bonds
There are many types of bonds, including those whose interest payments are exempt from income taxes. Some of the most common types of bonds include:
These are direct obligations of the U.S. government, which uses the money to finance the budget.
These bonds are issued by a state, municipality, or county to finance projects or operations. Municipal bonds are exempt from federal taxes. They may also be exempt from state and local taxes — if you live in the state in which the bond is issued.
These are issued by public and private companies. They typically are taxable, have a term maturity and are traded on an exchange. These bonds run from high-quality (or investment-grade) to junk (or high-yield).
What risks are associated with investing in bonds?
Just as bond ownership may offer potential benefits, it also comes with a variety of risks, including but not limited to:
- Credit risk: The bond issuer is unable to make payments on time.
- Liquidity risk: The bondholder won’t be able to sell the bond as quickly as desired.
- Prepayment risk: If a bond is repaid early, the bondholder receives their principal earlier than expected, which creates a loss of interest income.
- Default risk: The bond issuer defaults on payments — which means that bondholders don’t get some (or all) of their money back.
Speaking of default risk, there are several agencies that evaluate the creditworthiness of bond issuers and rate them based on the likelihood of default. The three best-known bond-rating firms are Standard & Poor’s (S&P), Moody’s, and Fitch.
Below is a breakdown of the ratings each agency assigns to bond issuers, and how those ratings translate to the issuer’s likelihood of default.
Information provided by SEI Investments Management Corporation. This information is for educational purposes only and should not be relied upon by the reader as research or investment advice. Investing involves risk, including possible loss of principal.