When governments need funding for infrastructure or corporations need finance to expand, they can issue a bond – effectively an “IOU” note. Each one has a face value, otherwise known as its par. They are then bought by investors, who become creditors to the organization that has borrowed the money. Bonds come with certain terms attached. A “coupon rate” is the level of interest that will be paid to the lender every year for the bond’s duration, and this could be fixed or variable. The “maturity date” stipulates when the borrower is obliged to pay back the face value of the bond.
Who issues bonds?
Government bonds are issued to fund day-to-day operations. They often have a maturity of more than 10 years. They are seen as a safe choice given how it is highly unlikely that a government would collapse, leaving them unable to reimburse creditors.
Corporate bonds work in a similar way, but they are regarded as riskier because there can be a higher likelihood of the company defaulting on its loan payment. As a result, the coupon rates attached to these bonds are usually higher.
Are bonds risky?
Bonds are generally regarded as a low-risk investment compared with stock markets and other types of financial instruments. Agencies including Moody’s and Standard and Poor’s use ratings to help guide investors on whether they are safe. Investment-grade scores on a scale of AAA to BBB- help illustrate the debtor’s capacity for meeting financial commitments. Non-grade investment scores, ranging from CCC to D, warn it is possible than loans may not be repaid.
As a rule of thumb, longer-term bonds are going to be riskier. It’s difficult to anticipate how interest rates will change when a maturity date is 10 or even 20 years down the line. There’s also inflation to think about: $1,000 may have seemed a lot in 2005, but won’t go as far in 2025.
What are bonds for?
Bonds are hardly the 007 of the investment world, but they serve an important purpose. Whereas there might be a limit to how much banks can lend, bonds mean governments and corporations can receive larger amounts from a broader range of sources. Investors also benefit because they can diversify their portfolio and reduce their exposure to risk.