Understanding bonds and their risks

A bond is a “IOU” for money lent to the bond’s issuer by an investor. The issuer undertakes to pay the investor interest at a certain rate known as the “coupon rate” in exchange for the usage of that money. When the bond “matures” at the conclusion of the agreed-upon time period, the issuer repays the investor’s principal.

Bonds offer diversity in an investor’s portfolio since they do not move in lockstep with equity investments. They also offer a consistent income stream for investors, generally at a greater rate than money market investments. Note that there are several exceptions, such as zero-coupon bonds and Treasury bills: When the bond matures, the interest income is removed from the purchase price, and the investor gets the entire face value of the bond.
Every bond has some “credit risk,” or the possibility that the bond issuer may fail on one or more payments before the bond matures. You may lose part or all of the income you were entitled to, as well as some or all of the initial amount invested, if you fail. Many bonds are rated by independent agencies such as Moody’s and Standard & Poor’s to assist determine credit risk (S&P). Based on the rater’s assessment of the issuer’s creditworthiness, ratings range from Aaa (Moody’s) through AAA (S&P) to D (for default). The highest credit ratings are Aaa (Moody’s) and AAA (S&P). “Investment grade” ratings are those that are higher than BBB (S&P) and Baa (Moody’s).
Bonds rated below investment grade (S&P BB or below, Moody’s Ba or lower) are commonly referred to as “junk” bonds.
second footnote They may be suitable for investors who are willing to accept greater price volatility and default risk in exchange for enhanced investment cash flow.
All bonds, like stocks, may expose an investor to price volatility (or “market risk”) if they are not held until the maturity date (when the original principal amount is repaid to the bondholder). If an investor is compelled to sell or liquidate a bond before it matures, and the bond’s price has dropped, he or she will lose a portion of the principal as well as the future income stream.

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