Investing In Bonds- How Is It Done And What Are The Risks?

Stocks and bonds. You have doubtlessly heard of them, and if you have been reading my articles, you know what they are. If you haven’t, here’s a quick update: stocks represent a fraction of ownership in a company, and a bond represents money that a company “borrowed” and has to pay back on set dates. You may have heard that bonds are “safer” to invest in than stocks, but is this true? How are bonds traded, and what are the differences between a stock market and a bond market? Hopefully, this article can put these questions to rest.

Unlike the stock market, bonds markets do not usually have a centralized trading system. Instead, bonds will be traded in decentralized, dealer based over the counter markets. When an investor buys or sells a bond, the counter party to the trade is almost always a bank acting as a dealer. Another difference between bond markets and stock markets is that sometimes investors don’t pay broker’s fees to dealers with whom they buy or sell bonds. Instead, the dealers get their money by collecting the spread, which is the difference between the price at which the dealer buys a bond from one investor and the price at which he sells the same bond to another investor.

In terms of volatility, bonds are usually somewhat safer than stocks, especially short and medium dated bonds, but the value of stocks can definitely change. Bonds are liquid – it’s fairly simple to sell a bond investment, and the safety of a fixed interest payment that you will receive twice a year is attractive. Bondholders additionally enjoy certain legal protections: in the United States if a company goes bankrupt, its bondholders will be paid before stockholders because they are creditors.

On the other hand, bonds also come with their risks. Fixed rate bonds are subject to interest rate risk, which means that their market prices will shrink in value when the interest rates rise. Bonds also can be subject to other risk factors such as call and prepayment risk, reinvestment risk, event risk, liquidity risk, credit risk, inflation risk, yield curve risk, volatility risk and sovereign risk. A bond that undergoes a price change can additionally affect mutual funds that hold these bonds immediately. If the value of the bonds in a trading portfolio has plummeted over the day, the value of the portfolio will also have fallen.

Finally, in the case of bankruptcy, because there is a hierarchy of creditors that must be paid that bondholders are not on top of, there is no guarantee of how much money will go to repay the bondholders even though the money will go to them first before shareholders. Bondholders have been known to lose some or all of their money when this happens.

Mallory Megan works for Rapid Recovery Solution and writes articles on national collection agencies. This article, Investing In Bonds- How Is It Done And What Are The Risks? is released under a creative commons attribution licence.