When you want to borrow money to buy a car or renovate your home, chances are you go to a bank or a local credit union. However, when a company wants to expand its business or when a government wants to modernize an airport, it issues bonds. Because bonds provide the capital that many institutions need to keep moving ahead, the bond market is also referred to as the capital markets.
A bond is a loan between the investor who purchases it and the company or government that issues it. The bond’s issuer promises to repay the loan on a certain date and to pay interest at a fixed rate. Bonds that are issued by local and state governments and the U.S. government have one more feature: The interest income they pay is generally exempt from some or all taxes.
A wide variety of bonds
The bond market is the world’s biggest financial market. In addition to corporate and government bonds, there are bonds backed by home, car and school loans. There are high-yield bonds whose issuers don’t have stellar credit ratings. There are bonds with short-, intermediate- and long-term maturities. And there are bonds that involve special wrinkles, such as call features, insurance and floating rates.
Investing for income and appreciation
Because bonds pay regular interest, investors often buy them as a source of income. But like stock, a bond’s value can rise and a bond may be sold for more than its face value. Bond mutual funds let investors reinvest income to purchase more shares. However, a bond fund’s shares can fluctuate in value because the fund must value its holdings every day to reflect what investors would be willing to pay for them in the secondary markets.
Bond market risks
There are special risks associated with certain segments of the bond market. However, rising interest rates and default risk are common to most market segments.
1. Interest rate risk
Generally speaking, when interest rates rise, the market price of a previously issued bond declines because newly-issued bonds offer to pay higher interest. Conversely, when interest rates come down, older bonds that pay higher interest become more valuable. Changing interest rates don’t affect the bond investor who holds a bond to maturity. And, the impact of changing interest rates differs from one type of bond to another
2. Default risk
If a bond issuer falls on hard times, it may default on its interest payments or even on its return of principal at maturity. Most bonds are rated by independent rating agencies, and ratings serve as a guide in assessing a bond’s level of risk. U.S. government bonds are the highest quality bonds because there is little risk that the federal government will default.