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 mutual funds. Still, in the U.S., nearly 10
percent of all bonds outstanding are held directly by
households.
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 they
will decrease in value when the generally prevailing interest rate
rises (the opposite is true for bonds with negative convexity e.g
bonds that allow for prepayment such as mortgage backed
securities). 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. 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.
Bonds can become volatile if one of the bond rating agencies like
Standard and Poor's or Moody's upgrades or downgrades the credit
quality of the issuing company or government. 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.
