Investment fundamentals: Bonds 101

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 until the bond becomes due at a specified date in the future. At that point, the issuer pays back the face value of the bond in full to the investor.

How does bond investing 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 do people invest in bonds?

Investors generally purchase bonds as a way to capture a steady income stream from the bond’s coupon payments (with the exception of zero-coupon bonds.)

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.
• Interest rate risk: Bonds and bond funds will decrease in value as interest rates rise.
• Liquidity risk: The bondholder will not 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.
• Prepayment risk: If a bond is repaid early, the bondholder receives their principal earlier than expected, which creates a loss of interest income.

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 ratings 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.

Categories of bonds

There are many types of bonds, including those whose interest payments are generally exempt from federal income tax income tax exempt. Some of the most common types of bonds include:

Treasury

These are direct U.S. government obligations, which are used to finance the budget.

Municipal

These bonds are issued by a state, municipality, or county to finance projects or operations. Municipal bonds are generally federal tax exempt. They may also be exempt from state and local taxes if you live in the state in which the bond is issued. As shown in the above chart, municipal bonds run from high-quality (i.e. investment grade) to junk (i.e. high-yield).

Corporate

These are issued by public and private companies. They typically are taxable, have a term maturity and are traded on an exchange. Corporate bonds are also rated by their quality (e.g. likelihood of repayment).

Important information

Information provided by SEI Investments Management Corporation (SIMC). 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. Bonds and bond funds will decrease in value as interest rates rise. There is no guarantee that the income from municipal bonds will be exempt from federal or state income taxes. Capital gains on municipal bonds, if any, are subject to capital gains tax. Income from municipal bonds may be subject to the alternative minimum tax. Diversification may not protect against market risk.

Neither SIMC nor its affiliates provide tax advice. Please note that (i) any discussion of U.S. tax matters contained in this communication cannot be used by you for the purpose of avoiding tax penalties; (ii) this communication was written to support the promotion or marketing of the matters addressed herein; and (iii) you should seek advice based on your particular circumstances from an independent tax advisor.