Investing in Bonds

Introduction to Bonds

Bonds are bought and traded mostly by institutions like pension funds, insurance companies and banks. Most individuals who want to own bonds do so through bond funds. Still, in the U.S., nearly ten percent of all bonds outstanding are held directly by households.

As a rule, bond markets rise (while yields fall) when stock markets fall. Thus bonds are generally viewed as safer investments than stocks, but this perception is only partially correct. Bonds do suffer from less day-to-day volatility than stocks, and interest payments of bonds are higher than dividend payments that the same company would generally choose to pay to its stockholders.

Bonds are liquid - it is fairly easy to sell bond investments, though not nearly as easy as it is to sell stocks - and the certainty of a fixed interest payment twice per year is attractive. Bond holders also enjoy a measure of legal protection: under the law of most countries, if a company goes bankrupt, its bond holders will often receive some money back (the recovery amount), whereas the company's stock often ends up valueless. However, bonds can be risky:

    * Fixed rate bonds are subject to interest rate risk, meaning that their market prices will decrease in value when the generally prevailing interest rates rise. Since the payments are fixed, a decrease in the market price of the bond means an increase in its yield.

When the interest rates rise, then the market price for bonds will fall, reflecting investors improved ability to get a good interest rate for their money elsewhere - perhaps by purchasing a newly issued bond that already features the newly higher interest rate. Note that this drop in the bond's market price does not affect the interest payments to the bond holder at all, so long-term investors need not worry about price swings in their bonds and do not suffer from interest rate risk.

However, price changes in a bond immediately affect mutual funds that hold these bonds. Many institutional investors have to mark to market their trading books at the end of every day. If the value of the bonds held in a trading portfolio has fallen over the day, the mark to market value of the portfolio may also have fallen. This can be damaging for professional investors such as banks, insurance companies, pension funds and asset managers.

If there is any chance a holder of individual bonds may need to sell his bonds and cash out for some reason, interest rate risk could become a real problem. (Conversely, bonds market prices would increase if the prevailing interest rate were to drop, as it did from 2001 through 2003.) One way to quantify the interest rate risk on a bond is in terms of its duration. Efforts to control this risk are called immunization or hedging.

    * Bond prices can become volatile if one of the credit rating agencies like Standard & Poor or Moody upgrades or downgrades the credit rating of the issuer. A downgrade can cause the market price of the bond to fall. As with interest rate risk, this risk does not affect interest payments of the bond, but puts at risk the market price, which affects mutual funds holding these bonds, and holders of individual bonds who may have to sell them.

    * A company's bond holders may lose much or all their money if the company goes bankrupt. Under the laws of many countries (including the United States and Canada), bond holders are in line to receive the proceeds of the sale of the assets of a liquidated company ahead of some other creditors. Bank lenders, deposit holders (in the case of a deposit taking institution such as a bank) and trade creditors may take precedence.

There is no guarantee of how much money will remain to repay bond holders. As an example, after an accounting scandal and a Chapter 11 bankruptcy at the giant telecommunications company Worldcom, in 2004 its bond holders ended up being paid 35.7 cents on the dollar. In a bankruptcy involving reorganization or re-capitalization, as opposed to liquidation, bond holders may end up having the value of their bonds reduced, often through an exchange for a smaller number of newly issued bonds.

    * Some bonds are callable, meaning that even though the company has agreed to make payments plus interest towards the debt for a certain period of time, the company can choose to pay off the bond early. This creates re-investment risk, meaning the investor is forced to find a new place for his money, and the investor might not be able to find as good a deal, especially because this usually happens when interest rates are falling.
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