There are many options available to investors in the securities markets. Bonds vary in risk levels. The risk coupled with the length of the bond valued against existing market conditions will determine the rate of return to the investor. Those who purchase bonds often automatically assume they are a less risky investment compared with stocks. This is not the case. It is important to understand how bonds function and what determines the return rate.
Bonds are debt securities otherwise known as debentures. They are issued for a specified term and offer a rate of return for the value loaned to the company. Bonds come at all levels of risk -- low, medium and high -- and are rated by bond-rating companies such as Moody's. The coupon determines the rate of the investment and can be a variety of maturity terms.
Long-term bonds also have ratings and coupons that determine their rate of return. This duration of bond is designed to give investors a higher rate of return by committing the loan for a longer period of time, generally more than 15 years until maturity. Long-term bonds are also referred to as "long bonds."
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Interest Rate Risk
Interest rate risk is the risk associated with a possible rise in interest rates in the duration of owning a bond. Long-term bonds have greater interest rate risk than short-term bonds. Investors buying long-term bonds in lower interest markets so they can maximize returns may see interest rates rise before the maturity of the bond and realize the current market value of the bond is below the face value. This means they would be liquidating the bond for less than invested to purchase a higher yielding investment. Note: If interest rates decline before maturity, the bond holder may keep the bond for the rate or sell it for a premium on the secondary market getting more than he invested.
Improved Interest Offering
Just as with mortgages, the shorter the term, the lower the rate. This is generally true for bonds. Under most normal economic conditions, the longer a person is willing to loan her money, the higher interest they will yield. This is a normal yield curve: Longer duration equals higher rates. This is not true in the case of an inverted yield curve.
The Yield Curve
The most common yield curve is described in the previous section, where the direct correlation is positive between time and rate. A flat yield curve is not very common where interest rates of short and long term bonds are equal. As a predictor of a recession, long-term rates have a lower yield than short-term rates of equivalent credit ratings. This is called an inverted yield curve or a negative yield curve.