You’re probably familiar with bonds, which are basically a loan you give to a company, government, or other organization in exchange for regular interest payments and, eventually, receiving your full investment (i.e., the face value or principal) at a set date in the future (i.e., the maturity date).
Bonds aren’t necessarily used to build wealth but more to protect it, while providing a designated income flow with the additional potential for capital appreciation.
In short, bonds can be a safe harbor in a market storm.
Take a closer look at the most common fixed-income market options, benefits, and risks.
How Do Bonds Work?
Bonds generally carry a set of designations:
- Coupon rate: The interest rate the bond pays each year based on its face value
- Maturity date: The date when the bond issuer repays the full principal to the investor
- Call date: The earliest date the issuer can repay the bond early (before maturity), if the bond is callable
- Credit rating: A grade given by rating agencies that shows how likely the issuer is to repay the bond (e.g., AAA = very safe)
- Repayment priority: Determines which investors get paid first if the issuer goes bankrupt—bondholders are usually repaid before stockholders
These designations allow investors to identify obligations that meet their specific risk tolerance level, income requirements, and repayment horizon. A bond’s yield-to-maturity or yield-to-call date will reflect its cash flow to the holder based on its purchase price, coupon payment, and time horizon to retirement. Yield-to-maturity assumes the bond is held until maturity and that an investor can reinvest at the same yield. Investors should evaluate an obligation’s taxability status at the federal and state levels to meet their specific tax liability requirements.
Individual Bonds
Individual bonds represent a lending arrangement between two parties, which can be either secured or unsecured obligations. They generally carry a designated maturity date with some period of early call (i.e., retirement) protection, along with a defined interest obligation payable by the borrower. However, exceptions occur for certain types of bonds.
Bonds, also known as credits, are primarily issued by the U.S. and foreign governments and their related entities, states and local municipalities, domestic and foreign corporations and banks, mutual companies, and real estate investment trusts. Additionally, pooled obligations (e.g., credit cards, mortgages, and auto loans) originate from both government-sponsored agencies and private lenders. These collateralized obligations offer various tranches of coupon payment options, maturity horizons, and credit risk levels. A bond’s interest payments can be either taxable or nontaxable, depending on the issuer, the taxability status of the account holder, and various tax authority regulations.
As a credit obligation, bonds carry default risks, which are generally designated by an accredited ratings entity such as Moody’s, Standard and Poor’s, or Fitch Ratings. Bonds are designated as either Investment Grade (IG) or high-yield and offer income flows commensurate with their credit risk.
Compared to the equity market, the bond market is vast, as any issuer could be responsible for originating numerous obligations. Investors can use individual credits to build a tailored maturity “ladder,” target specific market sectors, or focus on IG or high-yield exposure.
Exchange-Traded & Mutual Funds
Access to the fixed-income markets is also available through exposure via exchange-traded (ETF) and mutual funds. These funds could be either open-ended (i.e., perpetual) or offer specific retirement dates for the fund. They can be actively managed or passive in nature, where the latter track the performance of a designated comparable index.
ETFs and mutual funds offer many of the same features as individual bonds, but can somewhat mitigate default risk across a broad portfolio of holdings. These funds will offer a yield, credit exposure risk, and maturity retirement sensitivity reflecting their individual holdings’ composite consensus.
Through funds, an investor may also be able to tailor their sector exposure and credit risk tolerance to adhere to their personal preferences while also achieving some degree of targeted duration sensitivity. Fee expenses for funds will vary depending on the fund’s management style, costs, and other mitigating factors.
Whether an investor chooses to gain exposure to the fixed-income market through individual bonds, ETFs, or mutual funds, they are still subject to the same general benefits and risks associated with owning debt obligations—such as interest rate sensitivity, credit risk, and yield considerations.
Benefits of Owning Individual Bonds & Funds
Bonds can provide portfolio stability as they are often uncorrelated with equity market volatility. U.S. government and municipal obligations are supported by either designated revenue streams or by the taxing power of the authority. U.S. government-sponsored enterprises also enjoy this implied guarantee by association.
Bonds issued by corporations generally carry priority over equity in the capital structure, which helps to support their repayment probability. If held to maturity, individual bonds will provide the holder a return of principal and may also return a capital gain if they were purchased at a discount to their par value. In addition, bonds provide a designated income stream to their holders, which may be tax-advantageous to the holder.
Risks Associated With Individual Bonds & Funds
Bonds carry credit risk, which can come from an outright default on principal and interest by the borrower or a deterioration of asset credit quality. Bonds also carry interest rate risk, as they are highly price sensitive to fluctuations in market interest rates.
Finally, bonds are subject to reinvestment risks. Market fluctuations in interest rates may result in less advantageous reinvestment opportunities for cash flows from interest payments and return of principal. The return of principal may come at either the designated maturity date or prematurely if the bonds carry an early call provision.
Are you interested in exploring your fixed-income market options and learning more about how bonds work? We’ll gladly discuss your options and how these securities could help you protect your wealth and offer income flow. Speak with a Carlson Investments advisor today!
Carlson Investments does not provide tax, legal, or accounting advice. This content has been written for informational purposes only. Always consult your individual tax, legal, or financial professionals for advice tailored to your situation.
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