Bonds can play an important part in almost every investor’s portfolio, but many people remain ignorant of how they work. Understanding bonds and the parties involved is crucial to making smart investment decisions. A healthy bond portfolio can spell the difference between retiring in comfort and having to cut back on your standard of living.
A bond is a type of IOU. Purchasing a bond from an issuer represents a loan by the investor to the issuer in the amount of the bond's face value. The issuer, meanwhile, agrees to pay back to the investor the face value (or principal) of the bond once it matures. In the meantime, the issuer will pay the investor interest on the principal, usually making a payment once every six months. As you can see, the issuer and borrower are the same entity, since investors are lending the bond issuer money.
Unlike a loan from an individual, bonds are considered liquid investments. Investors aren't required to hold bonds until maturity waiting for the borrower to pay the principal back. Instead, an investor can sell a bond to someone else on the open market. As of year end 2012, the value of outstanding debt in the US bond market was over $38 trillion, according to the Securities Industry and Financial Markets Association, compared to only $18 trillion for the US stock market, according to the World Bank.
Since the issuer is acting as a borrower and the investor is acting as the lender, the investor needs to know how likely the issuer is to pay back the loan. This likelihood is reflected in the issuer's credit rating. A credit rating is a score for any entity that issues debt, roughly analogous to the credit rating a home-buyer might receive when applying for a mortgage. Ratings are provided by ratings agencies, independent organizations that evaluate the credit-worthiness of the issuer.
Ratings usually take the form of a three-letter designation, ranging from AAA or Aaa for very reliable borrowers to C, DDD or D, for issuers in default. A default occurs when an issuer is unable -- or unwilling -- to continue to pay the interest on the bond. Bonds rated BB+/Ba1 or below are considered "junk" or "non-investment grade" bonds, due to the likelihood of default. Bonds with a high perceived risk of default typically offer a higher interest rate payment to compensate investors for the increased risk. Ratings agencies aren't perfect, though. Just because a bond is rated AAA doesn’t meet the issuer can't default.
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