A bond represents a loan from you, the investor, to a company, municipality or government agency. The issuing organization needs money to operate, so it borrows money by selling bonds. Investors lend money to the organization by purchasing those bonds, in exchange for the promise of a return of the face amount of the bond at a fixed future date, plus interest payments. Bonds, like every investment, have pros and cons.
Bonds typically pay interest, although there are different ways that interest is paid. Some bonds make semiannual interest payments, while others are sold at a discount from their face value and accrue interest until they mature at face value. Regardless of how the interest is calculated or paid, the investor earns a predictable stream of income from his bond by collecting that interest.
Bonds are issued and redeemed by a specific company, government agency or municipality, but many bonds are traded in the secondary market. Bonds are interest-rate-sensitive, meaning the price of bonds in the secondary market is affected by prevailing rates. Bond prices tend to move in the opposite direction of prevailing rates, so if interest rates drop, the market price of your bonds will probably increase. If you sell your bonds for more than you paid for them, you get a capital gain on your investment in addition to any interest payments.
The secondary market can be a double-edged sword. Just as the market price of bonds tends to increase if interest rates drop, bond prices tend to fall when interest rates rise. The reason is simple: You wouldn't pay $1,000 for a bond paying 4 percent when you could spend $1,000 to buy a comparably rated bond paying 5 percent. The market price of the 4 percent bond must fall to stay competitive with prevailing rates. If you sell your bond for less than you paid for it, you have a capital loss.
Some bonds, such as U.S. Treasury bonds, are backed by the full faith and credit of the U.S. government, and they carry very little risk. That level of safety does not apply to most bonds. A bond is only as safe as the organization that issued it. If the issuing organization has a financial downturn, it might not be able to meet its debt obligations. It could miss interest payments and default on its bond obligations. If the issuing organization goes bankrupt, bondholders have a superior claim over stockholders to the company's assets. But if there is not enough to go around, bondholders could lose money.
- Securities Industry and Financial Markets Association: What Are Bonds?
- Securities Industry and Financial Markets Association: Why Invest in Bonds?
- Securities Industry and Financial Markets Association: Key Bond Investment Considerations, Part 1
- Securities Industry and Financial Markets Association: Key Bond Investment Considerations, Part 2
- CNNMoney: Bond Investing Basics
- Securities and Exchange Commission: Bonds
- Comstock/Comstock/Getty Images