A bond is a debt instrument that a corporation or government borrows to finance projects for a certain period at a fixed or variable interest instead of getting the loan from a bank. Its price is at face or par value of $1,000 per bond, but once they come in the open market, the price can be lower (discount), or higher (premium) than the face value. When interest rates go down, it is at a premium, an investor will receive a lower coupon yield. Bonds trade at a premium when the coupon rate is higher than the prevailing interest rate. Bond prices are not volatile like stocks but are sensitive to interest rate changes. This safety feature is the reason for bonds being favoured over stocks during retirement. The factors that influence bond rating are financial stability, current debt and growth potential. Junk bonds offer higher returns but these have a greater risk.
- Interest rates and bond prices have an inverse relationship (when interest rates fall, the price of bonds rises and vice versa), and will affect returns if forced to sell
- Reinvesting proceeds at a lower rate than previously, and when callable bonds are exercised by the issuer prior to maturity
- Erosion of purchasing power when rates are negative to inflation
- Corporate bonds are not guaranteed, and are dependent on the issuer’s ability to repay debt, and not default
- Liquidity risk, when the bonds cannot be sold quickly due to fewer buyers and sellers
- May be difficult to sell the bonds if a company’s credit rating is low due to its inability to repay loan