Bonds are issued by corporations and governments to raise money. When you purchase a bond, you are lending the issuer money. In return, the issuer pays you interest in regular intervals and then the face value of the bond when it matures.
Usually, the interest rate is constant throughout the life of the bond, with the exception of floating rate bonds, which are tied to a separate, prevailing interest rate.
Interest Rate Risk
Bonds are considered safer investments than stocks because they pay a steady interest rate, and if the company goes bankrupt the bondholders recover their investments before stockholders. U.S. government-issued bonds are even safer because it is considered impossible that the government will default.
There still exists a risk with all bonds known as "interest-rate risk." If you purchase a bond that pays an interest rate of 5 percent for example, and then the prevailing interest rate increases such that a bond that pays 6 percent interest can be purchased at the same price, the price of your bond will decrease. After all, who would want your bond at the old price when a better bond can be purchased for the same amount?
Buying and Selling Bonds
Interest rate risk doesn't change the amount you will receive from the issuer; the corporation or government will dutifully pay the 5 percent interest. However, if you try to resell the bond on the open market, you will get a lower price than what you originally payed. Likewise, of everyone else is making 6 percent, your 5 percent return won't have the same purchasing power.
Likewise, if interest rates fall, your bond will be worth more. For example, if interest rates decrease to 4 percent, your 5 percent bond will be a very attractive investment.
Hedging Against Inflation with TIPS
When interest rates are near zero, it is far more likely that interest rates will rise than fall, mainly because they can't fall any further. Treasury inflation protected securities (TIPS) offer a way to purchase government bonds without the risk of the value falling. The solution is simple: The interest rate paid by the TIPS increases with inflation. As inflation rises along with interest rates, TIPS offer a safer investment in this type of environment. TIPS pay a slightly lower interest rate than normal treasuries, but the "resale" value of the TIPS remains steady.
Other Kinds of Floating Rate Bonds
There are corporate floating rate bonds that are primarily issued by banks that are betting on interest-rate declines. If you believe that interest rates will rise, you can purchase these bonds either individually or through a mutual fund or an exchange traded fund (ETF).
Some people like to purchase bonds because the investor can easily calculate how much they will pay over time. You lose this predictability with floating-rate bonds, so for older investors depending on a fixed income, floating rate bonds may be a poor choice.
Ethan Markowitz is a freelance training and marketing specialist living in Los Angeles, CA. While earning his MBA part-time at UCLA, he consults for several entertainment and hi-tech companies and has a proven track record increasing sales, customer retention, and brand awareness.