Just as stock investors buy equity in a company, bond investors buy debt.
Companies and governments issue bonds, collecting cash—the bond’s face
value or par value—up front from investors. The issuers agree to make
interest payments, usually semiannually, for a set time before paying the
money back.
In most cases, the payment remains the same for the life of the bond. For
this reason, bonds and other securities that make regular payments are
classified as fixed-income. In later chapters, during the discussion about
how to craft a portfolio, you’ll read about seeking a balance between
equities and fixed-income (or stocks and bonds).
Estimates vary regarding the size of the U.S. bond market—which
contains debt issued by corporations, the federal government, and
municipalities—but most peg the bond market at roughly twice the size of
the stock market.
Bonds come in many varieties. Here are a few of the most common:
Corporate bonds. Debt issued by corporations.
Treasury bonds. Debt issued by the U.S. Treasury and backed by the
full faith and credit of the federal government. Investors both in the
United States and overseas generally consider Treasury bonds free of
default risk.
Agency bonds. Debt issued by agencies connected to the federal
government. While such bonds don’t technically have the backing of the
U.S. Treasury, most investors assume they have extremely low risk of
default.
Municipal bonds. Debt issued by states, municipalities, or agencies
connected to states or municipalities, such as water systems. In most
cases, the interest payments from these bonds are not subject to
federal income taxes.
High-yield bonds. Also known as junk bonds, any securities with a
speculative-grade rating fall into this group. Remember the concept:
“High risk, high return. Low risk, low return.”
Convertible bonds. Companies can issue bonds that, under certain
conditions, convert into stock.
Variable-rate bonds. In some cases, bond issuers make interest
payments that fluctuate based on changes in a benchmark interest rate.
When you buy a bond, you make a bet on the creditworthiness of the
issuer. If a bond issuer can no longer cover the payments, it may default on
the bond, leaving investors in the lurch. The risk of default is known as
credit risk.
Credit-rating agencies—Standard & Poor’s, Moody’s, and Fitch Ratings—
assess the creditworthiness of companies and governments that issue
bonds and assign them ratings. Those ratings reflect the agencies’ opinions
on the likelihood that the issuer will default. For example, S&P’s ratings
range from AAA to D, with everything BBB-and higher classified as
investment-grade. The agency considers every bond with a rating of BB+ or
lower speculative-grade.
Standard & Poor’s issues AAA ratings only for the financially strongest
companies. Fewer than 15 countries and only four companies earn AAA
ratings from S&P.
Bonds As An Investment.
