The Securities Industry and Financial Markets Association reports that the U.S. bond market had an average daily trading volume of $814.0 billion in 2009 compared to $104.9 billion for the NYSE, NASDAQ and AMEX stock exchanges. Most individuals possess at least a cursory understanding of stocks (equities) and the relationship to finance and the general economy. However, bonds (debt securities) remain a complete mystery to the majority of people.
Many individuals would likely associate bonds with a type of investment their grandparent would own. While bonds simply do not have the sex appeal of stocks, many investors have left the risk and anxiety of large daily fluctuations of the stock market for the relative calm of the bond markets.
A bond is a loan made by a bond buyer or investor to an issuer. The issuers consist of private corporations – corporate bonds, local governments – municipal bonds, federal government – treasury bonds or government-sponsored enterprises (Fannie Mae or Freddie Mac). International corporations and foreign government also issue bonds.
These entities have a need to raise large amounts of cash for a variety of projects, such as infrastructure, schools, new factories, research and development, business operations or social programs.
In return for the investment, the bond buyer– individual or organization– receives regular interest payments on a predetermined schedule (usually quarterly or semi-annually) until the bond reaches maturity or the issuer “calls” the bond. At this point, the issuer repays the principal to the investor.
Some key jargon used in bond investing includes the following terms:
- Coupon or Yield – refers to the interest rate
- Face Value – The amount borrowed/invested
- Maturity date – The date on which the issuer must repay the face amount
- Fixed-income – The precise amount of cash the issuer pays if the bondholder keeps the security until the maturity date
An investor who buys a bond with a face value of $1000, coupon rate of 6% and a 5-year maturity date, will receive a total of $60 in interest payment over each of the next five years. At the maturity date, the issuer returns the $1,000 principal to the investor.
These investors gladly accept a lower return in exchange for lower risk of their retirement nest egg. In addition, bonds pay a higher interest rate compared to investments in money market or certificates of deposit.
The investor and issuer in a bond transaction have a creditor-debtor relationship. As a creditor of a corporation or government entity, the bondholder does not receive a share of corporate profits. In contrast, an investor who purchases stock buys an ownership share of the corporation.
As an owner in the business, stockholder has voting rights and a claim to the proportionate share of corporate profits. Voting rights means the stockholder can vote on issues related to corporate policies, including business actions, changes in the corporate operations or issuing corporate stock.
In the event of bankruptcy, the bondholder has a superior claim on assets and receives any payment due before a shareholder.
Bonds Have Less Risk
When the stock market takes a downturn into bear market territory, astute investors seek safety and predictable income of bond market investments. Therefore, many investors allocate a larger portion of their assets to bonds. Most people close to retirement have an affinity for bonds, compared to equities, because enable them to sleep better because of less volatility.