When you purchase a bond, you loan money to the issuer for a fixed period of time. Like any lender, you run the risk that the borrower will fail to repay the debt. Technically, a bond is in default if the issuer fails to make a scheduled payment. This can happen for a variety of reasons and doesn't necessarily mean that you stand to lose your entire investment.
In many instances, the purchase price of a bond is the same as the par value in which case you receive interest payments over the course of the bond term. A temporary cash flow problem may cause the issuer to miss a payment but this does not directly affect your chances of redeeming the bond for par value at maturity. Other types of bonds are sold at a discount to par in which case compounded interest payments cause the bond to reach its par value at maturity. In such instances, your bond will not reach its par value unless the bond issuer catches up on past due payments before the bond matures.
While some bond defaults are quickly rectified, other defaults are the first step on the road to the issuer filing bankruptcy. If a corporation becomes insolvent, liquidators seize and sell the firm's assets. Cash from the sale is used to settle delinquent taxes and pay past due wages. Thereafter, bondholders have the opportunity to make claims on the firm's assets. Stockholders get nothing until the claims of the bondholders have been settled. In many instances, bankruptcies result in negotiated settlements with bondholders having to settle for less than they are owed.
Municipal bonds fall into two categories: general obligation bonds and revenue bonds. General obligation bonds are sold to raise money for key government backed projects such as new roads or schools. These bonds are backed by tax dollars. If the bond issuer defaults on loan payments, it can resolve the issue by raising additional cash through new taxes or through cutting other spending. In contrast, revenue bonds are attached to specific projects such as toll roads. Generally, the issuer has no liability to settle the debt if the project in question becomes insolvent.
Federal government bonds are viewed as the least risky investments even though the government could in theory default on its debts. If this happened, the federal government could raise taxes or cut spending in which case you should expect to redeem your bond for par value. The same applies to bonds issued by foreign governments, although you could get back less than expected if the dollar weakens in relation to foreign currencies. Mortgage bonds are tied to loan payments. The issuer may default if borrowers default on mortgage payments. You may get back little or nothing when you redeem your bond if large numbers of mortgages end up in default.
You cannot entirely eliminate the risks associated with any type of bond investing. However, credit rating agencies regularly assess the default risk associated with bond issuers. In theory, higher rated bonds are less likely to go into default. As with any investment, the risks are inextricably linked to the potential rewards. If you invest solely in low-risk bonds then you should expect to get lower than average yields. On the other hand, you can potentially earn higher returns if you are willing to risk some of your principal and invest in lower rated bonds.
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