A bond is a borrowing tool issued by companies, governments, or other entities. By purchasing a bond, investors lend money to the issuer. Bonds are traded in the secondary market, and holders can receive principal and interest at maturity. The issuer promises to repay the principal at maturity and pays interest (the "coupon") periodically. Since the issuer may face financial difficulties, the return of the principal and interest to investors is not guaranteed.

Basic Concepts of Bonds

Bonds are similar to IOUs, where the issuer (borrower) commits to repaying the principal on a future date (maturity date) and paying interest regularly. The main components of a bond include principal, interest, and maturity date. For example, a bond with a face value of $1,000, an annual interest rate of 5%, and a term of 10 years will repay $1,000 at maturity and pay $25 in interest every six months.

Issuers of Bonds

Issuers can be categorized as follows:

1. Corporations: Companies issue bonds to raise funds for business expansion, acquisitions, or other capital needs. For instance, Anheuser-Busch InBev (NYSE: BUD) issued $46 billion in bonds in 2016 to finance its acquisition of SAB Miller.

2. Municipal Governments: Local or state governments issue municipal bonds ("munis") to fund infrastructure projects. Interest income from these bonds may be tax-exempt for residents, but specific tax treatment should be confirmed with a tax advisor.

3. Federal Government: Bonds issued by the U.S. federal government (like Treasury bonds and bills) are backed by U.S. government credit and are considered the lowest-risk bond type.

4. Other Entities: Universities, public transportation agencies, and other organizations may also issue bonds to fund development projects.

Common Types of Bonds

Bonds come in various types, each with different characteristics:

• Convertible Bonds: Allow holders to convert the bond into shares of the issuing company's stock. They usually offer lower interest rates due to the conversion option.

• Zero-Coupon Bonds: Do not pay periodic interest but are issued at a price lower than their face value. Investors' returns come from the difference between the maturity value and the purchase price.

• Callable Bonds: Issuers or investors can redeem the bond before maturity. Callable bonds typically offer lower interest rates to compensate for the risk of early redemption.

Bond Market

Like stocks, bonds are traded in public securities markets. Investors can purchase bonds through bond brokers or indirectly invest in bonds through bond mutual funds. Bond prices and interest rates are closely related:

• Interest Rates: Bond interest rates are usually linked to the issuer's credit rating. Higher-rated bonds have lower interest rates, while lower-rated bonds offer higher rates to compensate for higher default risks.

• Prices: Bond prices are inversely related to market interest rates. When market rates rise, existing bonds with fixed rates become less attractive, causing prices to fall. Conversely, when market rates decline, bond prices increase.

Risks of Bonds

Although bonds are generally less risky than stocks, they still carry certain risks:

• Default Risk: The risk that the bond issuer fails to make interest payments or repay the principal. Defaults typically relate to company bankruptcies, where bondholders may not recover their full investments.

• Interest Rate Risk: When market rates rise, existing bonds with lower rates may decline in value. Investors should monitor market interest rate changes to manage bond investment risks.

Bond Ratings

Credit rating agencies like Fitch Ratings, Moody's, and Standard & Poor's evaluate the credit risk of bond issuers and publish rating reports:

• Investment-Grade: Indicates moderate to low default risk. For example, bonds rated Baa by Moody's or BBB by Standard & Poor's and above.

• Non-Investment Grade: Known as "junk bonds," indicating higher default risk, typically requiring higher interest rates to attract investors.

Fixed-Income Investment

Bonds are termed "fixed-income" investments because they usually provide fixed interest payments. This feature is particularly appealing to investors who rely on stable income, such as retirees. Banks and financial institutions' fixed-income departments focus on bond trading, using market fluctuations to devise investment strategies for profit.

Overall, bonds serve as a relatively stable investment tool, providing consistent returns, but investors must understand their risk characteristics and market dynamics to make informed investment decisions.