A bond is a fixed-income instrument representing a loan made by an investor to a borrower, typically a corporation or government, with agreed interest payments and principal repayment at maturity.
A bond is a form of debt security where the issuer borrows funds from investors and promises to pay fixed interest payments, known as coupons, at specified intervals until the bond matures. At maturity, the issuer repays the principal amount, also called the face or par value. Bonds are used by governments, municipalities, and corporations to raise capital for various projects and operational needs. Typically, bonds have a stated maturity date and coupon rate, which may be fixed or variable. The value of a bond in the market fluctuates based on interest rate changes, credit risk of the issuer, and overall economic conditions.
Understanding bonds is critical for wealth managers and family offices as they often represent a core component of diversified investment portfolios aiming for income and capital preservation. Bonds provide predictable cash flows through interest payments, which can support liquidity needs or help meet fixed cash flow targets. Moreover, bonds typically have lower volatility compared to equities, helping reduce overall portfolio risk. Effective bond selection and management influence tax efficiency, as different types of bonds may have varying tax treatments, and governance in monitoring credit risk is essential to mitigate default risk and protect capital.
An investor purchases a corporate bond with a face value of $10,000, a 5% annual coupon rate, and a maturity of 10 years. The investor will receive $500 in interest annually and the $10,000 principal back at the end of 10 years. If interest rates decline, the bond’s price may rise above $10,000, reflecting its higher fixed coupon compared to new issuances.
Bond vs. Bond Fund
While a bond is an individual debt security with specific terms, a bond fund pools money from multiple investors to invest in a diversified portfolio of bonds. Bond funds pool risk and offer liquidity, unlike holding individual bonds which may have different maturity schedules and credit profiles. However, bond funds do not have fixed maturities and may expose investors to interest rate risks.
What happens if the bond issuer defaults?
If the issuer defaults, they fail to pay interest or principal on time, which can lead to a loss of income or principal for the investor. The bond’s credit rating helps assess this risk before investing.
How does interest rate change affect bond prices?
Bond prices and interest rates have an inverse relationship. When interest rates rise, existing bond prices fall because newer bonds offer higher yields, and vice versa.
Are all bonds taxed the same way?
No. Tax treatment varies; for example, municipal bonds may be tax-exempt at federal (and sometimes state) levels, while corporate bond interest is generally taxable.
