The Basics of the Bond Market

Corporations and governments often require more capital than banks can provide. So, they turn to investors for financing. Investors lend such entities their money in return for a small yield, creating a bond.

Unlike stockholders, bondholders do not acquire partial ownership of the issuer. They do, however, rank higher in bankruptcy situations, meaning they receive their funds before stockholders.

Bonds are rated by

, Standard & Poor's and Fitch. Moody's ratings range from Aaa to C while the other two rate bonds from AAA to D. Issuers of Aaa/AAA bonds are considered to be of the highest quality while issuers of C/D bonds are in default.

Bonds generally offer less risk than equities, given the fact that bondholders have a higher claim on assets than stockholders. And, in the case of government bonds, the issuer's theoretically unlimited tax powers act as a fail safe. Thus, bonds are typically favored by those who cannot afford to lose their principal. These include investors who are approaching retirement, those who need a given amount of money in the short-term (ex: someone buying a home in two years may take out a two-year US Gov. bond) and the like. Conservative investors, such as those who would otherwise stuff their money under a mattress, may favor the low risk bonds offer, as well. And, bonds are particularly favored during times of economic distress. For example, many investors parked their assets in bonds at the height of the financial crisis to limit their exposure to the rapidly-declining stock market.

Security comes at a price, as bonds offer low yields. For example, as of this writing, bond yields range from 0.02 percent (US Treasury – 3 months) to 4.86 percent (corporate – 20-year A). The low end is virtually nothing and, even at the high end, the average stock would offer more than double the return. Also, if interest rates decline, the issuer may call the bonds, leaving the investor to reinvest at a lower rate. Conversely, if rates rise, the investor will be committed to a bond yielding rates below the market average.

While the entire bond market cannot be adequately explained in one article, we've discussed the very basics of this type of investment. It is important to remember that bonds allow corporations and governments to borrow funds banks cannot provide them with. And, the “lenders” (bondholders) are creditors, not share owners. Finally, bonds offer lower risk than equities, but at a lower rate of return. In a nutshell, bonds are for those looking for a conservative investment in lieu of high-risk/high-reward stocks.