Tuesday, June 30, 2009

Exactly What is a Bond?

Corporate and government entities issue bonds as a way of borrowing money. Investors purchase bonds (lend money) in exchange for interest payments and the promise that the loan will be repaid in the future. A typical bond specifies the date when the loan will be repaid (the maturity date), and the amount of interest to be paid every six months until the bond matures (the coupon). A bond’s coupon does not change, which is why bonds are frequently referred to as “fixed-income” investments. As bond purchasers are only loaning money, they have no rights of ownership in the entity borrowing the money.

The holder of a bond is paid its face value (usually $1,000) on the maturity date. A bond purchaser can usually sell the bond to another investor before the maturity date, but in doing so, gives up the right to receive coupon payments. The market price of a bond is determined by comparing the coupon rate of the bond with that of other bonds with similar risks. If the coupon rate is lower than that of other bonds, the bond will likely sell at discount (less than $1,000). If the bond is currently paying a higher coupon than that of other bonds, the bond will likely sell at a premium (more than $1,000). Often, investors are willing to pay more than the face value of the bond in exchange for receiving a higher coupon.

While bonds are typically considered to be a low-risk investment, they have several types of investment risk. Interest rate risk is the risk associated with a decline in the value of a bond as interest rates rise. Since coupons are fixed, existing bonds will be worth less if interest rates rise because newer bonds will offer higher coupons.

Default risk refers to the possibility that a bond issuer will not be able to make interest payments or repay the bond. To minimize this risk, pay attention to a bond’s rating, which is an evaluation of the entity’s creditworthiness. If an entity’s credit is shaky, its bonds are often referred to as "junk bonds."

Call risk is the possibility that a bond issuer could prepay the loan. When interest rates decline, entities often pay off their loans and then issue new debt at lower interest rates. When this happens, investors must reinvest their principle, likely at a lower interest rate.

Lastly, purchasing power risk refers to the possibility that interest and principle payments will not be as valuable due to the effects of inflation. Again, coupon payments are fixed, so if inflation increases, coupon and principle payments will purchase less.

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