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What are bonds?
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What are bonds? Definition and meaning
How do bonds work?
- Face value: the amount the bond is for
- Coupon rate: the interest rate
- Maturity date: the date when the loan has to be repaid
- Payment frequency: how often the bond earns interest
Who issues bonds?
- Governments: National, state, and local governments issue bonds to fund various projects and operations. These are often called government bonds or sovereign bonds.
- Corporations: Companies issue bonds to raise capital for expansion, acquisitions, or other financial needs. These are typically referred to as corporate bonds.
- Municipalities: Local governments, such as cities, towns, or counties, issue municipal bonds to finance infrastructure projects like schools, roads, or utilities.
- Government-Sponsored Enterprises (GSEs): Entities like Fannie Mae (Federal National Mortgage Association) and Freddie Mac (Federal Home Loan Mortgage Corporation) in the U.S. issue bonds to support specific sectors of the economy, such as housing finance.
- Supranational organizations: Institutions like the World Bank or International Monetary Fund (IMF) issue bonds to fund projects and initiatives that promote economic development globally.
Investing in bonds
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Risks of bond investing
- Interest rate risk: Bond prices typically move inversely to interest rates. When interest rates rise, bond prices fall, and vice versa. This can affect the value of your bond investments, especially if you need to sell before maturity.
- Credit risk: The value of a bond is connected to the creditworthiness of its issuer, and some bonds are rated more highly than others. Corporations with lower credit ratings or governments facing financial instability are considered higher-risk issuers, for example. There’s a greater chance that they could default on the bond or that their creditworthiness could drive down the bond’s price — which means capital loss for the bondholder. Higher-risk issuers may offer higher coupon rates to compensate for the added risk.
- Inflation risk: Bonds provide fixed interest payments, which can be eroded by inflation over time. If inflation rises unexpectedly, the purchasing power of the bond's future interest payments and principal repayment may decrease.
- Liquidity risk: Some bonds may have limited liquidity, meaning there may not be many buyers or sellers in the market. This can make it challenging to sell your bonds at a fair price, especially in times of market stress.
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