What is a bond? A bond is a written promise to pay back loaned money, an IOU. In addition to promising to pay back the loaned money, a bond also specifies how much has been borrowed, and exactly when the loaned money is to be paid back. Bonds are debt obligations. A bond is a contract between an issuer who is borrowing the money, and a bondholder, the lender.
If you are a stockholder, you are a part-owner of the company you are invested in. When you purchase a bond, you are a creditor of the company. A bondholder expects to earn interest at a fixed rate of return from the investment they are making. A bond is a record of the loan and the terms of repayment.
Bonds are fixed-income securities. Bonds pay interest over a fixed term, or period of time. Bonds mature at the end of the term of the loan, and the principal, or amount loaned, is repaid to the lender/owner of the bond in addition to the interest earned. The rate of interest that is to be paid is determined at the time the bond is offered for sale.
A corporate bond is an investment instrument issued by a company or corporation for the purposes of raising capital. Companies issue bonds in order to finance the research, development, and improvement of their products, and also to build and finance the growth of their business in order to compete successfully in the marketplace.
How bonds are rated
The two main investment rating services for bonds are Moody’s and Standard & Poor’s. Moody’s and Standard & Poor’s are investment advisory service companies. Bond ratings are based on a detailed evaluation by these advisory services of the underlying financial condition of companies offering the bonds for sale. They evaluate the bond issuer’s ability to pay back the debt obligation once it matures, just as a bank would if you were to apply for a loan. Moody’s and Standard & Poor’s rate all types of corporate and municipal bonds. They do not rate U.S Treasury bonds.
Like individuals, some companies pay back their debt obligations, and some don’t! Like individuals, some companies are more creditworthy than others. If a company is more likely to pay back their debt obligation based on how sound the company may be and what the company’s past credit history has been, then the bond issued by the company will be rated higher than a less creditworthy company.
Investment grade refers to those bonds rated Baa or higher by Moody’s, or BBB or higher by Standard and Poor’s. Investment grade bonds involve less risk. The principal, the amount initially invested by the lender, and also the interest due at maturity, will more likely be paid back than a lower-rated, non-investment grade bond. At the opposite end of the bond-rating spectrum are so-called junk bonds.
Bond ratings (highest to lowest) for Moody’s and Standard & Poor’s are as follows:
Moody’s – Aaa, Aa, A, Baa, Ba, B, Caa, Ca, C, D
Standard and Poor’s – AAA, AA, A, BBB, BB, B, CCC, CC, C
Incorporating bonds into an overall investment strategy
Conservative investors buy and hold bonds for the income they can provide, and also in order to preserve capital. Aggressive investors will trade bonds, as with stocks, in order to make a profit on a bond that has increased in value.
Bonds provide a means of apportioning investment assets into a well-balanced, diversified investment portfolio, adding stability to your overall asset allocation. In general, bonds will reduce and even out overall investment risk. They represent the fixed-income portion of an investment portfolio.
If you are currently building assets for the purpose of creating long-term retirement savings, then the primary reason to invest in bonds is to preserve the wealth represented by that portion of capital you have already accumulated that you want to protect and keep safe. Bonds are used to preserve wealth. Stocks are used to build wealth.
Scott, David L. 1988. Wall Street Words. Boston: Houghton Mifflin Company
Quinn, Jane Bryant. 1997. Making the Most of Your Money. New York: Simon & Schuster
Standard & Poor’s – Overview (http://www2.standardandpoors.com/portal/site/sp/en/us/page.topic/aboutsp_overview/4,1,1,0,0,0,0,0,0,0,0,0,0,0,0,0.html)