While the stock market tends to attract more headlines, the bond market is about 80 percent larger in terms of total value. Generally speaking, bonds are less volatile than stocks, and are purchased by institutional and private investors to generate income and diversify portfolios.
Bonds are referred to as fixed income investments, paying interest to purchasers based on the amount invested. They can be offered by corporations, cities, states or the federal government. Bonds are made up of two primary components -- principal and interest. The principal of a bond is the face value of the sum borrowed, while the interest is the yearly amount paid on the investment. Bonds can be issued with maturities that range from less than a year to more than 30 years. At maturity, the principal is paid back to investors.
The Agreement Between Parties
Bonds are offered for a variety of reasons, including the funding of current debts, building infrastructure, access to working capital and the expansion of operations. To gain access to funds, issuers agree to pay investors a fixed rate of interest based on the amount of bonds purchased at face value. Zero coupon bonds offer an alternative type of offering that is purchased by investors at a discount to face value. Instead of paying interest, when this type of bond matures investors are paid the face value of the bond. The difference between the purchase price and the redemption at face value is referred to as imputed interest.
Generally speaking, the credit quality of the issuer will determine the amount of interest that is paid, with higher interest rates compensating for greater levels of risk. For example, a bond issued by the U.S. government, which is considered risk-free if held to maturity, would pay less interest than a bond offered by a company that has only recently started to generate revenues.
Pros and Cons for Issuers
Bonds offer municipal and government issuers access to capital above and beyond the revenues collected via local, state and federal tax collection. The issuance of bonds often is seen as a more popular alternative for both taxpayers and politicians than increasing income taxes. For corporations, bonds offer access to capital without the dilution of ownership that accompanies selling shares in the company. Moreover, the interest payments on bonds are tax-deductible.
The biggest disadvantage for issuers is that bonds are structured to pay a fixed level of interest until maturity. If interest rates should decline after a bond’s issuance, the issuer would be stuck paying above-market rates, potentially until the bonds mature. A second disadvantage of issuing bonds is that an expanding level of debt can increase the perception of risk related to the issuer. An increasing risk profile can force issuers to pay higher interest rates for subsequent bond offerings.
Pros and Cons for Investors
Bonds are purchased as a means of generating a predictable amount of income on the amount invested. Municipal and government bonds also carry tax advantages on their interest payments. These fixed income investments allow investors a high level of predictability when planning for future cash flows and budgets. An additional advantage when investing in high quality issues such as U.S. Treasuries and insured municipals is that there is no risk to principal as long as bonds are held to maturity.
A key disadvantage of investing in bonds is that inflation can erode the buying power of fixed interest payments over time. For example, an investor receiving $10,000 annually in fixed income from bonds would lose buying power as the cost of goods and services increases each year. A second disadvantage is that issuers can build call features into their bonds. This allows issuers to retire bonds at a preset date and price prior to maturity if current market rates are lower than the interest being paid on a bond. For example, a 6 percent bond that matures in 2030 could have a call feature that would allow the issuer to retire the bond and return principal to investors in 2020. If interest rates on similar bonds are substantially lower than 6 percent in 2020, the bond could be called and a subsequent offering generated at a more business-friendly rate.