A bondholder denotes a moneylender offering funds to the bond-issuing entity. Bonds are debt instruments issued by the government or corporation to obtain capital to finance their projects. They come with a fixed interest or coupon rate remitted periodically to the holder and assurance of repayment of original bond value at maturity.
Bonds are negotiable instruments and hence can be traded in secondary markets. Bondholders can choose to hold the bond accumulating the interest earnings over time and redeeming it at the end of its tenure. Or else, they can sell the bonds at a relatively higher price in the bond market, cashing in the profits. However, they lose the right to gain interest earnings after selling the bonds.
Types of Bonds
Two main forms of bonds are government or municipal and corporate bonds. National or local government issues government or municipal bonds to fund their spending, while corporates count on it for financing long-term investments and short-term operations.
The US Treasury issued Series I Bond and Series EE Bond are two well-known examples of government bonds. Corporate bonds have varying attributes and denominations. For instance, they may be short-term or long-term, secured or unsecured, redeemable or irredeemable bonds, junk, or convertible.
The key difference between the two is that government bonds offer lower interest rates, viz-a-viz corporate bonds. However, interests on them are exempt from taxes, making them attractive as a tax-saving instrument for many.
Risks Faced by Bondholders
Bondholders have to deal with the possibility of bond issuers failing to repay the principal or interest. This is referred to as default risk. Since government bonds have the backing of the government, they are less likely to default and are less risker than corporate bonds.
Bondholders also face interest rate risks. When the interest rates of the bonds rise, their prices decline. This is because investors buy bonds that provide a higher interest rate, and hence, the value of the bond issued earlier declines.
Besides the default risk and interest rate risk, bondholders are exposed to inflation risks. This means that the bond value may not offset the inflation over the years and hence yield less value at maturity.
Prospective bondholders should assess the risk of a bond before buying by checking its credit rating published by credit rating agencies like S&P, Moody's, and Fitch.
How to Buy Bonds
Bondholders can acquire bonds via:
- Direct purchase through the issuing establishment, or
- Indirect purchase of existing bonds through a monetary authority or dealer on the secondary market.
Thus, a bond is more like a loan agreement between the creditor (bondholder) and the debtor (corporation). As a result, bondholders enjoy a low-risk investment with a predetermined income. However, potential bond investors must know the interest rate, maturity date, and credit ratings before funding.
