|
|
|
|
Bonds are bought and traded mostly by institutions like
pension funds, insurance companies and banks. Most individuals who want to
own bonds do so through bond funds. Still, in the U.S., nearly ten percent
of all bonds outstanding are held directly by households.
As a rule, bond markets rise (while yields fall) when stock markets fall.
Thus bonds are generally viewed as safer investments than stocks, but this
perception is only partially correct. Bonds do suffer from less day-to-day
volatility than stocks, and bonds' interest payments are higher than
dividend payments that the same company would generally choose to pay to
its stockholders. Bonds are liquid — it is fairly easy to sell one's bond
investments, though not nearly as easy as it is to sell stocks — and the
certainty of a fixed interest payment twice per year is attractive.
Bondholders also enjoy a measure of legal protection: under the law of
most countries, if a company goes bankrupt, its bondholders will often
receive some money back, whereas the company's stock often ends up
valueless. However, bonds can be risky:
Fixed rate bonds are subject to interest rate risk, meaning their market
price will decrease in value when the generally prevailing interest rate
rises. Since the payments are fixed, a decrease in the market price of the
bond means an increase in its yield. When the market's interest rates
rise, then the market price for bonds will fall, reflecting investors'
improved ability to get a good interest rate for their money elsewhere —
perhaps by purchasing a newly issued bond that already features the newly
higher interest rate. |
New Articles on Trading Bonds |
|
|
|
This drop in the bond's market price does not affect the interest payments
to the bondholder at all, so long-term investors need not worry about
price swings in their bonds.
However, price changes in a bond immediately affect mutual funds that hold
these bonds. Many institutional investors have to "mark to market" their
trading books at the end of every day. If the value of the bonds held in a
trading portfolio has fallen over the day, the "mark to market" value of
the portfolio may also have fallen. This can be damaging for professional
investors such as banks, insurance companies, pension funds and asset
managers. If there is any chance a holder of individual bonds may need to
sell his bonds and "cash out" for some reason, interest rate risk could
become a real problem. (Conversely, bonds' market prices would increase if
the prevailing interest rate were to drop, as it did from 2001 through
2003.) One way to quantify the interest rate risk on a bond is in terms of
its duration. Efforts to control this risk are called immunization or
hedging.
Bond prices can become volatile if one of the credit rating agencies like
Standard & Poor's or Moody's upgrades or downgrades the credit rating of
the issuer. A downgrade can cause the market price of the bond to fall. As
with interest rate risk, this risk does not affect the bond's interest
payments, but puts at risk the market price, which affects mutual funds
holding these bonds, and holders of individual bonds who may have to sell
them.
A company's bondholders may lose much or all their money if the company
goes bankrupt. Under the laws of the United States and many other
countries, bondholders are in line to receive the proceeds of the sale of
the assets of a liquidated company ahead of some other creditors. Bank
lenders, deposit holders (in the case of a deposit taking institution such
as a bank) and trade creditors may take precedence.
There is no guarantee of how much money will remain to repay bondholders.
As an example, after an accounting scandal and a Chapter 11 bankruptcy at
the giant telecommunications company Worldcom, in 2004 its bondholders
ended up being paid 35.7 cents on the dollar. In a bankruptcy involving
reorganization or recapitalization, as opposed to liquidation, bondholders
may end up having the value of their bonds reduced, often through an
exchange for a smaller number of newly issued bonds.
Some bonds are callable, meaning that even though the company has agreed
to make payments plus interest towards the debt for a certain period of
time, the company can choose to pay off the bond early. This creates
reinvestment risk, meaning the investor is forced to find a new place for
his money, and the investor might not be able to find as good a deal,
especially because this usually happens when interest rates are falling.
|
|