Bonds and CDs

Think of a bond as a loan where you (the investor) are the lender. In exchange for the use of your money, the borrower—typically a corporation or governmental entity—promises to pay you a fixed amount of interest at regular intervals. The borrower further agrees to repay the amount borrowed to you at a specified date in the future.

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Bond prices and interest rates have what’s called an inverse relationship. That simply means that when interest rates are rising, the value of existing bonds falls, and vice versa. Why, you may ask? Let’s look at an example. Say that you own a bond currently paying 3%. Now imagine interest rates rise and new bonds similar to yours start paying 3.5%. Your bond becomes less attractive because investors will prefer the new, higher-yielding bonds. So what if you want to sell your bond? You’ll have to ask for a price that’s lower than what you originally paid, so that the purchaser will in effect be receiving a 3.5% yield. Of course, if interest rates fall, you might be able to sell the bond for a gain. One common way to manage the risk of rising interest rates is through a bond ladder (see question below).

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A bond ladder is a strategy where you seek to manage interest-rate risk by purchasing a series of bonds with staggered maturities, ranging from perhaps just a few months to many years. If interest rates rise, you can invest the principal from the maturing short-term bonds in new, higher-yielding bonds. If rates fall, you’ll continue to enjoy the high yields of your longer-term bonds. In either case, you’ll be earning income on your entire bond portfolio all the while.

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You can think of new issue bonds like stocks in an initial public offering. It’s the first time those particular bonds are available for purchase by the general public. Secondary market bonds are previously owned bonds that are being sold on an exchange by one investor to another.

A bond’s credit rating is the likelihood that the issuer will have the financial wherewithal to make interest payments and return the principal as promised. Bonds are rated by firms such as S&P and Moody’s on a scale that ranges from prime investment-grade on the high end to extremely speculative (or even in default) on the lower end. Generally speaking, bonds with lower credit ratings must pay higher yields as incentive for investors to assume the greater risk of purchasing them.

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Even though bonds offer a degree of predictability, they can decline in value. For example, the bond’s issuer may experience financial difficulties and become unable to make interest payments or repay the principal amount as promised. Also, rising interest rates can cause bond prices to fall. If you needed to sell your bonds prior to maturity in such a scenario, you could receive back less than you paid.