There are fundamentally two types of security investments: debt and equity. A debt security is a bond, and an equity security is a stock.  Issuing bonds is an important way for different issuers to raise money to fund projects or build capital. The most common bond issuers include federal governments, federal agencies, municipalities, and corporations. While all these entities can issue bonds, only a corporation can issue stock.

What is a Bond?

Bonds and stocks represent very different investments to an investor.  When an investor buys stock in a corporation, that investor becomes a partial owner. The stock offers the possibility of capital appreciation and dividend payments to the stockholder, with no guarantee that either of these will occur. A bond, on the other hand, makes a promise of a return to the bondholder. The issuer agrees to pay the bondholder a fixed interest payment regularly until the bond's maturity, at which point the issuer will pay the original face value of the bond. As a bondholder, the investor becomes a creditor of the issuer and has a senior claim on the liquidation of assets over stockholders if the issuer were to file bankruptcy.  Bondholders also must receive their contractual payment before stockholders can be given income through dividends.

Bonds are issued with three essential components:

1. Maturity — Maturity indicates the life of the bond. Most bonds have maturities ranging from three months to 30 years.
2. Par value — Par value, also called face value, is the amount the bondholder will be repaid when the bond reaches maturity. For instance, if you purchase a $1,000 par value bond, you will receive $1,000 at maturity.
3. Coupon rate — Coupon rate (also referred to as interest rate) is the percentage of par value paid to bondholders on a regular basis. For example, if you purchase a $1,000 par value bond with a 5% coupon rate, you will receive $50 interest each year and a return of principal at maturity.

Bonds offer investors many of the unique advantages compared to alternative investments:

• Safety (or capital preservation) — Because the bond issuer must pay back the bond's face value at maturity, all or virtually all of an investor's original principal is preserved, unlike stock, where the investor can lose the original investment value. The degree of safety varies with bonds of different types and ratings.
• Fixed return — Investors receive fixed, regular interest payments, which provide an element of predictability versus common stocks where the returns are less certain.
• Current income — For those wanting a regular cash income, bonds provide regular interest payments at set times.
• Reduce portfolio risk — Due to their more certain nature than stocks and their tendency to behave opposite of stocks in unfavorable stock market times, bonds are a great way to reduce the risk in an investment portfolio.

Not All Bonds Are the Same

There are many different types of bonds.  Bonds are separated by purpose, issuer, collateral, and credit rating.  Following are the major categories of bonds issued:

• Federal government bonds — U.S. government bonds are issued by the Treasury and help finance various federal operations.    
• Federal agency bonds — Federal agencies issue bonds, many of which are indirect obligations of the U.S. government, to support financing specific to their operations. The most well-known agencies support home financing, education, and public power facilities.
• Municipal bonds — Municipalities such as states, cities, counties, and towns issue bonds to fund various publicly beneficial projects, including building and operating schools, roads, sewer systems, and convention centers.
• Mortgage-backed securities — As a way to provide funding to the mortgage market, certain federal agencies and some private organizations issue bonds backed by groups of mortgages and deriving payments from the underlying mortgage payments.
• Corporate bonds — Many corporations raise money through the issuance of debt. The funds raised through bonds are often used for modernization, expansions, new product ideas, or financing operating expenses. Corporations can issue two types of debt: secured and unsecured. Bonds that are secured have a pledge of collateral backing the original principal amount. Unsecured bonds, called debentures, have no collateral backing, so they rely solely on the issuer's ability to repay principal and make timely interest payments.

How is a Bond's Price Determined?

After a bond is first issued, it trades in the secondary market composed of buyers and sellers of outstanding securities (similar to stock markets). A bond's price will fluctuate in the secondary market above or below the original issue price to reflect changing market conditions. However, purchasers of the original issue don't need to worry about price movements of their bonds because such fluctuations won't affect the payback of the bondholder's original principal amount at maturity, the par value. This return of principal, regardless of price volatility, is one of the key benefits of holding bonds.

Several factors drive bond price movements. The major factors are:

• Interest rate levels --The most important cause of bond price fluctuations is the changing level of interest rates. As illustrated below, when interest rates in the market rise, a bond's price will fall. Conversely, if interest rates fall, a bond's price will rise. For example, suppose that you purchase a 3% coupon bond of XYZ Company at its primary issue price, the par value of $1,000. Assume that two years from now, the bond is trading in the secondary issue market. At this point, market interest rates have fallen, and new bonds similar to yours are being issued at a par price of $1,000 but are paying only a 2% coupon rate consistent with market conditions. Understandably, other buyers in the market would be willing to pay a premium, more than $1,000, for your bond that has the higher 3% coupon rate. Therefore, this bond's price will increase to reflect prevailing rates; this bond trades at a premium price. If you sold your premium bond, you would have a gain on your original purchase. Consider the opposite case. Two years from now, interest rates have risen, and a new bond selling for $1,000 is paying a 4% coupon rate. It would be impossible to sell your bond for $1,000 if it only pays a 3% coupon rate when new bonds offer a higher interest rate. To sell your bond, you will have to offer it at a discount to entice a buyer to buy your bond. If you sold your discount bond, you would register a loss from your original purchase price of par value.
• Credit quality -- Changes in an issuer's credit quality will also affect the price of its bonds. This factor is most common with non-U.S. government issuers such as corporate and municipal issuers. An issuer's credit quality is evaluated according to its ability to make timely principal and interest payments to bondholders. Bonds are evaluated for credit risk based on the financial performance of the issuer, both past, and present. The major rating agencies for bonds are Standard & Poor's and Moody's Investors Service. Issuers pay these credit rating agencies a fee to rate both their financial performance and the likelihood that the issuer will be able to meet future debt obligations. This credit rating influences the price at which an issuer must compensate an investor for the risk involved in loaning money to their company. Investment-grade bonds are those bonds whose risk of defaulting on interest and principal payments is low to modest, based on evaluating the issuer's current and projected financial performance. Bonds rated below investment grade, sometimes referred to as "high yield" or "junk" bonds, are from issuers whose current financial position is either speculative or uncertain in their ability to make principal and interest payments. Bonds rated below investment grade typically have higher coupon rates because companies must compensate investors with a higher return for taking on extra risk. It is important to note that Treasury securities are not rated because they are considered free of credit risk. Treasuries are backed by the full faith and credit of the U.S. government, which guarantees the repayment of principal and interest. Most government agencies are also not formally rated but have an implied AAA rating.
• Length to maturity -- With any given change in interest rates, bonds with longer maturities will tend to have greater price swings compared to shorter maturity bonds.  
• Supply and demand factors -- At any point in time, a bond's price may be driven by excess supply or demand factors for the particular bond or bond class.

Risks of Investing in Bonds 

As with any type of financial investment, bonds include some degree of risk. Determining your risk tolerance is a crucial element to consider when investing in bonds and developing a portfolio strategy.

• Credit risk -- The risk associated with the issuer's ability to make timely principal and interest payments to its creditors. The U.S. government is considered to have the least credit risk of all bond issuers. Federal agencies have only somewhat greater credit risk than the U.S. government due to the close relationship with the government. Corporate and municipal bonds are rated by the two major credit rating agencies — Moody's and Standard & Poor's — on an "alphabetical" scale. While these two agencies ' ratings are very similar, they are not identical.
• Interest rate risk -- Also referred to as market risk, is the risk that rising interest rates will cause a bond's price to fall and decrease the value of an investment. However, how much a bond's price will move for any 1% change in interest rates will depend on many factors such as its credit risk, time to maturity, coupon rate, and supply and demand conditions. Bonds with longer maturities or lower coupon rates have a greater percentage change in their price with a move in interest rates. Bonds that have shorter maturities and higher coupon rates tend to have more price stability.
• Marketability risk — The risk that the bond will be difficult to sell, affects some classes of bonds more than others.
• Call risk — The risk that an issuer may redeem a bond earlier than its original maturity date. This risk is more relevant during periods of declining interest rates.
• Purchasing power risk — The risk that inflation will lower the value of a bond's principal and interest payments.
• Reinvestment risk — The risk that as coupon payments are received on a bond, they must be reinvested at lower interest rates.

The Role of Bonds in a Diversified Portfolio

Bonds are an important part of a diversified portfolio, offering stability and income to a portfolio.  Bonds are considered a defensive asset class because they are typically less volatile than some other asset classes such as stocks. The stock market can offer a wild ride in the short-term, often seeing temporary dips of at least 10% at some point during the year on an annual basis.  Though the stock market generally comes back from these dips to make new highs ultimately, there is no guarantee that this will always be the case and it can take time depending on the state of the economy and mood of investors.  Against this backdrop, bonds can offer a steadier option. They have risk too, but generally see more stability over the short term. As such, by combining stocks and bonds, you may get a smoother ride as an investor. Bonds are likely to rise less over time if history is any guide. Yet, bonds are less likely to fall off a cliff when recession looms. In fact, historically speaking, bonds generally increase in value during stock market selloffs, making them one of the best assets to pair with stocks in a portfolio.   To learn more, see our Insight entitled "Building an Investment Portfolio for Retirement."

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