When you as an investor buy a bond, you are lending money to the company that issues the bond. Basically, the bond is a promise to repay the face value of the bond plus a specified interest rate within an agreed upon period of time.
Types of Bonds
There are various types of bonds, and these include
- US government securities
- Municipal bonds
- Mortgage and asset-backed funds
- Foreign bond
- Corporate bonds
Corporate bonds are issued by companies and are either private or public companies. There are also bond rating services that calculate the risk inherent in each bond and the chances of default or failure to pay. These agencies assign a series of letters to each bond issue, representing its risk factor.
Bond Ratings and Risks
And when it comes to ratings, bonds rated triple-A (AAA) are the most reliable and less risky. Meanwhile, bonds rated triple-B (BBB) and below are the riskiest. The agencies calculate the ratings using a mix of factors like financial stability, current debt, and growth potential.
In a diversified portfolio, highly-rated corporate bonds of short-term, medium-term, and long-term maturity can be useful for accumulating money for retirement, saving for college education, or establishing a cash reserve for emergencies.
Buying and Selling
Some corporate bonds can be traded publicly or on the over-the-counter market, offering good liquidity, which is the ability to quickly and easily sell the bond for ready cash.
This feature is important, particularly if you’re planning to be active on your bond portfolio. Investors may be able to buy bonds from this market or buy the initial offering of the bond from the issuing company in the primary market.
Primary market purchases may come from brokerage firms, banks, bond traders, and brokers. All of these take a commission for facilitating the sale.
Bond prices are quoted as a percentage of the face value, based on $100.
The interest on bonds are often paid every six months. On the highest rated bonds, the payments are reliable sources of income. Bonds with the least risk pay lower rates of return.
The higher risk bonds try to provide a higher return although they are less reliable to attract buyers and lenders.
When the prices of bonds decline, the interest rate hikes since the bond costs less. However, the interest rate remains the same as the initial offering.
On the flipside, when the price of a bond rises, the effective yield decreases. Long-term bonds often provide a higher interest rate because of the unpredictability of the future.
A company’s financial stability and profitability may change over the long term and may not be the same as when it initially offered the bonds. To mitigate this risk, bonds with longer maturity dates pay a higher interest.
Meanwhile, a callable or a redeemable bond may be redeemed by the issuing company prior to the maturity date. The downside for investors is that if a yield bond is called, they would lose the interest return for the years remaining in the life of the bond.
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