There are four primary categories of bonds sold in the markets. However, you may also see foreign bonds issued by corporations and governments on some platforms. The bonds available for investors come in many different varieties. They can be separated by the rate or type of interest or coupon payment, by being recalled by the issuer, or because they have other attributes.
Zero-coupon bonds do not pay coupon payments and instead are issued at a discount to their par value that will generate a return once the bondholder is paid the full face value when the bond matures.
Treasury bills are a zero-coupon bond. Convertible bonds are debt instruments with an embedded option that allows bondholders to convert their debt into stock equity at some point, depending on certain conditions like the share price. The convertible bond may be the best solution for the company because they would have lower interest payments while the project was in its early stages.
If the investors converted their bonds, the other shareholders would be diluted, but the company would not have to pay any more interest or the principal of the bond. The investors who purchased a convertible bond may think this is a great solution because they can profit from the upside in the stock if the project is successful.
They are taking more risk by accepting a lower coupon payment, but the potential reward if the bonds are converted could make that trade-off acceptable. Callable bonds also have an embedded option but it is different than what is found in a convertible bond. A callable bond is riskier for the bond buyer because the bond is more likely to be called when it is rising in value. Remember, when interest rates are falling, bond prices rise. A puttable bond allows the bondholders to put or sell the bond back to the company before it has matured.
This is valuable for investors who are worried that a bond may fall in value, or if they think interest rates will rise and they want to get their principal back before the bond falls in value.
The bond issuer may include a put option in the bond that benefits the bondholders in return for a lower coupon rate or just to induce the bond sellers to make the initial loan.
A puttable bond usually trades at a higher value than a bond without a put option but with the same credit rating, maturity, and coupon rate because it is more valuable to the bondholders. The possible combinations of embedded puts, calls, and convertibility rights in a bond are endless and each one is unique. Generally, individual investors rely on bond professionals to select individual bonds or bond funds that meet their investing goals.
The market prices bonds based on their particular characteristics. A bond's price changes on a daily basis, just like that of any other publicly traded security, where supply and demand in any given moment determine that observed price. But there is a logic to how bonds are valued. Up to this point, we've talked about bonds as if every investor holds them to maturity. It's true that if you do this you're guaranteed to get your principal back plus interest; however, a bond does not have to be held to maturity.
At any time, a bondholder can sell their bonds in the open market, where the price can fluctuate, sometimes dramatically. The price of a bond changes in response to changes in interest rates in the economy. This difference makes the corporate bond much more attractive. When interest rates go up, bond prices fall in order to have the effect of equalizing the interest rate on the bond with prevailing rates, and vice versa. Another way of illustrating this concept is to consider what the yield on our bond would be given a price change, instead of given an interest rate change.
YTM is the total return anticipated on a bond if the bond is held until the end of its lifetime. Yield to maturity is considered a long-term bond yield but is expressed as an annual rate.
In other words, it is the internal rate of return of an investment in a bond if the investor holds the bond until maturity and if all payments are made as scheduled.
YTM is a complex calculation but is quite useful as a concept evaluating the attractiveness of one bond relative to other bonds of different coupons and maturity in the market.
The formula for YTM involves solving for the interest rate in the following equation, which is no easy task, and therefore most bond investors interested in YTM will use a computer:. We can also measure the anticipated changes in bond prices given a change in interest rates with a measure known as the duration of a bond.
Duration is expressed in units of the number of years since it originally referred to zero-coupon bonds , whose duration is its maturity.
Who Is the Motley Fool? Fool Podcasts. New Ventures. Search Search:. Dan Caplinger. How do bonds work? How to make money from bonds There are two ways to make money by investing in bonds. The first is to hold those bonds until their maturity date and collect interest payments on them. Bond interest is usually paid twice a year. The second way to profit from bonds is to sell them at a price that's higher than what you pay initially.
Bond prices can rise for two main reasons. If the borrower's credit risk profile improves so that it's more likely to be able to repay the bond at maturity, then the price of the bond typically rises. Also, if prevailing interest rates on newly issued bonds go down, then the value of an existing bond at a higher rate goes up. Investing in bond funds Bond funds take money from many different investors and pool it all together for a fund manager to handle. Types of bonds Bonds come in a variety of forms, each with its own set of benefits and drawbacks.
Corporate bonds -- These tend to offer higher interest rates than other types of bonds, but the companies that issue them are more likely to default than government entities. Municipal bonds -- Also called muni bonds, these are issued by states, cities, and other local government entities to finance public projects or offer public services. For example, a city might issue municipal bonds to build a new bridge or redo a neighborhood park.
Treasury bonds -- Nicknamed T-bonds, these are issued by the U. Because of the lack of default risk, they don't have to offer the same higher interest rates as corporate bonds. How to buy bonds Unlike stocks, most bonds aren't traded publicly, but rather trade over the counter , which means you must use a broker. If sold before maturity, the bond may be worth more or less than the face value. Rising interest rates will make newly issued bonds more appealing to investors because the newer bonds will have a higher rate of interest than older ones.
To sell an older bond with a lower interest rate, you might have to sell it at a discount. Inflation risk. Inflation is a general upward movement in prices. Inflation reduces purchasing power, which is a risk for investors receiving a fixed rate of interest.
Liquidity risk. Call risk. The possibility that a bond issuer retires a bond before its maturity date, something an issuer might do if interest rates decline, much like a homeowner might refinance a mortgage to benefit from lower interest rates.
Corporate bonds are securities and, if publicly offered, must be registered with the SEC. Be wary of any person who attempts to sell non-registered bonds. Most municipal securities issued after July 3, are required to file annual financial information, operating data, and notices of certain events with the Municipal Securities Rulemaking Board MSRB. This information is available free of charge online at www.
If the municipal bond is not filed with MSRB, this could be a red flag. Test your knowledge on common investing terms and strategies and current investing topics. Learn about investing risks in certain companies that provide exposure to China-based businesses. Diversification : Including bonds in an investment portfolio can help diversify the portfolio. Many investors diversify among a wide variety of assets, from equities and bonds to commodities and alternative investments, in an effort to reduce the risk of low, or even negative, returns on their portfolios.
Potential hedge against an economic slowdown or deflation : Bonds can help protect investors against an economic slowdown for several reasons. The price of a bond depends on how much investors value the income the bond provides.
Inflation usually coincides with faster economic growth, which increases demand for goods and services. On the other hand, slower economic growth usually leads to lower inflation, which makes bond income more attractive. An economic slowdown is also typically bad for corporate profits and stock returns, adding to the attractiveness of bond income as a source of return. If the slowdown becomes bad enough that consumers stop buying things and prices in the economy begin to fall — a dire economic condition known as deflation — then bond income becomes even more attractive because bondholders can buy more goods and services due to their deflated prices with the same bond income.
As demand for bonds increases, so do bond prices and bondholder returns. In the s, the modern bond market began to evolve. Supply increased and investors learned there was money to be made by buying and selling bonds in the secondary market and realizing price gains. Until then, however, the bond market was primarily a place for governments and large companies to borrow money.
The main investors in bonds were insurance companies, pension funds and individual investors seeking a high quality investment for money that would be needed for some specific future purpose. As investor interest in bonds grew in the s and s and faster computers made bond math easier , finance professionals created innovative ways for borrowers to tap the bond market for funding and new ways for investors to tailor their exposure to risk and return potential.
The U. Broadly speaking, government bonds and corporate bonds remain the largest sectors of the bond market, but other types of bonds, including mortgage-backed securities, play crucial roles in funding certain sectors, such as housing, and meeting specific investment needs. Gilts, U. A number of governments also issue sovereign bonds that are linked to inflation, known as inflation-linked bonds or, in the U.
But, unlike other bonds, inflation-linked bonds could experience greater losses when real interest rates are moving faster than nominal interest rates.
Corporate bonds : After the government sector, corporate bonds have historically been the largest segment of the bond market. Corporations borrow money in the bond market to expand operations or fund new business ventures. The corporate sector is evolving rapidly, particularly in Europe and many developing countries. Speculative-grade bonds are issued by companies perceived to have lower credit quality and higher default risk than more highly rated, investment grade companies.
Within these two broad categories, corporate bonds have a wide range of ratings, reflecting the fact that the financial health of issuers can vary significantly. Speculative-grade bonds tend to be issued by newer companies, companies in particularly competitive or volatile sectors, or companies with troubling fundamentals.
While a speculative-grade credit rating indicates a higher default probability, higher coupons on these bonds aim to compensate investors for the higher risk. Ratings can be downgraded if the credit quality of the issuer deteriorates or upgraded if fundamentals improve. Emerging market bonds : Sovereign and corporate bonds issued by developing countries are also known as emerging market EM bonds.
Since the s, the emerging market asset class has developed and matured to include a wide variety of government and corporate bonds, issued in major external currencies , including the U.
Because they come from a variety of countries, which may have different growth prospects, emerging market bonds can help diversify an investment portfolio and can provide potentially attractive risk-adjusted returns.
Mortgage-backed securities and asset-backed securities are the largest sectors involving securitization. Credit spreads adjust based on investor perceptions of credit quality and economic growth, as well as investor demand for risk and higher returns. After an issuer sells a bond, it can be bought and sold in the secondary market, where prices can fluctuate depending on changes in economic outlook, the credit quality of the bond or issuer, and supply and demand, among other factors.
Broker-dealers are the main buyers and sellers in the secondary market for bonds, and retail investors typically purchase bonds through them, either directly as a client or indirectly through mutual funds and exchange-traded funds.
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