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Introduction to Bonds

Terminology

Bond

A bond is a contract between a corporation (or government agency) and an investor where the investor loans the corporation (or government agency) a certain amount of money for which the investor receives an agreed upon interest payment.

Inflation

Inflation results from an increase in the supply of money which has the effect of increasing demand for the goods and services businesses provide. This in turn allows these businesses to this increase their prices to the extent where consumers are still willing to pay these higher prices.

Risk

Risk is the likelihood of losing money. The higher the risk then the higher the likelihood of losing money.

Benefits and Risks of Bonds

Investing in Bonds for Beginners - Benefits and Risks of Bonds; Picture of a tablet lying on a wooden table with bonds displayed symbolizing Benefits and Risks for bond investors.

Be aware that bonds are not guaranteed

Bonds are fairly Safe

Bonds are generally considered to a fairly safe investment and tend to be popular with investors who are fairly conservative with their risk profile.

The interest payment that the bond investor will receive for the duration of the bond is known in advance.

Also, the capital that will be returned at maturity is known in advance, it's simply the face value of the bond (which is not necessarily the price paid for the bond).

Risks with Bonds

Bonds are not guaranteed and there are some risks with bonds that the bond investor needs to be aware of and these are outlined below:

Risks with Bonds:

  • Interest payment risk: Bond investors are relying on the bond issuer's ability to continuingly make the interest payments up to the maturity date (some long-term bonds having maturities of 30 years and more).
  • Capital repayment risk: Bond investors are again relying on the bond issuer's ability to actually repay the face value of the bond at maturity.
  • Bankruptcy risk: Corporate bonds are issued by companies and there is always the risk that at some future date the company may wind up in bankruptcy.
  • Bond recall risk: The bond issuer may terminate a bond prior to its maturity date. This can occur if interest rates decline and the bond issuer effectively refinances their higher interest paying bonds with new bonds issued at a lower interest rate.
  • Inflation risk: The face value of most bonds are not adjusted for inflation which is not much of an issue with short-term bonds. However with long-term bonds which can have maturities of over 30 years, inflation has a significant effect on the returns obtained from bonds.
  • Liquidity risk: After a bond is issued they can be sold to a bond dealer on the over-the-counter (OTC) market. Some bonds are popular and are easily sold to a bond dealer. A bond dealer will only buy a bond from an investor if they can easily sell it to another investor. Thus there is the risk that if the bond investor decided to sell their bond, they can not sell it a bond dealer.
  • Resale value risk: The value of a bond is based on the time remaining till maturity and on the current interest rate environment. If interest rates rise after the bonds issue, then newly issued bonds will be more appealing to bond investors, thus lowering demand and hence value of the older lower interest rate bonds.

While the risks from investing in bonds are relatively low, the bond investor still needs to be aware that they are not risk-free.

The lowest risk bonds are treasury bonds, followed by municipal bonds and then corporate bonds.

For bonds issued at the same time with the same maturity, treasury bonds will typically have the lowest interest rates and corporate bonds will have the highest interest rates.

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