Define: Bonds (aka Bonds, Just Bonds)
The Bond Market - alas, not a place filled with young Sean Connerys and Daniel Craigs for sale– is the trading of bonds and promissory notes. At the most basic level, bonds are instruments that banks, corporations and even the government use to raise money through debt. The main issuers of bonds are Corporations (corporate bonds), Municipalities (municipal bonds), and the U.S. Government (treasuries).
Bonds are essentially loans over a specified period of time from the investor (the person who buys the bond) to the issuer (the group borrowing the cash), who promises to repay the amount borrowed (the cost of the bond) along with interest payments at a fixed rate over a specified period of time.
Bonds are commonly referred to as fixed income securities because as the name suggests, there is a defined interest payment schedule and cash flow stream (typically semi-annually), and your original investment is usually returned after a specific term when the bonds have matured. However, the investor is subject to market risk in the form of interest rate volatility and credit risk.
The value of your bond fluctuates as interest rates rise or fall, making it more or less valuable than other bonds depending on its terms. Bond values vary with the market. With each drop in interest rate, your bond could be worth more, since it pays a higher rate. But the reverse is also true with each interest rate increase; a bond loses value, since its rate is lower than the current market standard. The lure of bonds is the fact that despite all the fluctuations of the market, in most cases, you’ll still get your interest payments and principal back at maturity. “Maturity’ refers to the end of the set period of the loan, when the bond is repaid.
Bonds may seem as old fashioned as Ms. Moneypenny’s style in the early Bond films, but as an investment they usually pose less risk than stocks because they have both a fixed rate of interest and an obligation of repayment in full…not necessarily a bad deal in a market that faces the R word.
Risk in investing in bonds comes from the issuer’s ability to make interest payments and repay the principal (the cash you have lent them). Even buying a bond from a big corporation with strong earnings and lots of capitol runs some risk. That corporation may have a massive product recall, and maybe even a lawsuit or two. Then, poof, the value of your bond as a security to be traded diminishes.
Bonds also expose investors to the risk of inflation, because payment of principal and interest is fixed when the bond is first issued and those payments may be worth less, in actually buying power if inflation reduces the value of a dollar. The money just doesn’t go as far as it did when the bond was bought, and the interest rate may not make up for that difference.