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 1
the coupon rate is the rate of interest that the company or government will pay the bondholder 2 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 3some 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 4 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 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 5 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 6some 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 7the 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 8in august 2023 fitch downgraded the long term ratings for the united states the rating dropped from aaa to aa fitch stated the move was due to the increasing national debt and the potential for fiscal deterioration over the next three years 9bondholders earn incomebondholders 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 2besides 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 10 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 11rewards and risks for bondholdersthe 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 being a bondholder is generally perceived as a low risk endeavor when compared to other types of investments such as stocks that s because bonds which are fixed income investments guarantee consistent interest payments and the return of principal at maturity in the case of corporate bankruptcies bondholders are commonly among the first to be reimbursed common stockholders on the other hand are on the lower rungs of the repayment ladder although there are certain tax implications associated with certain bonds there are some bond categories that provide holders with tax free interest payments this means the investor doesn t have to declare the interest as income and can net the entire amount as profit 2the 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 are susceptible to inflation risk bondholders also must deal with 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 for example corporate bonds generally yield higher returns than holding government bonds but they come with higher risks 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 12bondholders can earn a fixed income with regular interest or coupon paymentssafe risk free investment with u s treasury optionsbondholders receive payment in a corporate bankruptcy before common stock shareholderssome municipal bonds provide tax free interest paymentsinterest rate risk when market rates are risingcredit and default risk can happen to corporate bonds tied to the issuer s financial viabilityinflationary risk if inflation outpaces the bond s coupon ratea bond s face value on the secondary market may decrease when market interest rates outpace the coupon rateexamples of bondholderspotential bondholders can invest in government bonds or corporate bonds below is an example of each with the benefits and risks 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 13treasury bonds are long term bonds maturities between 10 to 30 years providing semiannual interest payments and face values of 1 000 for instance the 30 year treasury bond yield closed at 2 817 on march 31 2019 so the bondholder receives 2 817 yearly at maturity in 30 years they receive the fully invested principal back t bonds can sell on the secondary market before maturity 14microsoft msft has a series of corporate bonds or notes that it issues to raise capital many of them are long term fixed income assets that mature within 30 years issued on dec 6 2013 its maturity date is dec 15 2013 and trades on the secondary market on aug 17 2023 the bond s yield was 5 0142 which means the bondholder gets 5 0142 on an annual basis 15