Bondholders: Definition, Benefits, and Examples
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Summary:
A bondholder is an individual or entity that invests in bonds issued by corporations or governments. Bondholders provide capital to bond issuers and, in return, receive periodic interest payments and the return of their principal investment upon maturity. This article explores the role of bondholders, the benefits and risks they encounter, and key considerations for potential bond investors. It also delves into the differences between government and corporate bonds, the potential for losses, and the advantages and disadvantages of being a bondholder. Whether you’re a novice or seasoned investor, understanding the dynamics of bondholding is crucial for making informed investment decisions.
Understanding the backbone of debt investment
When it comes to investing, bonds represent a significant part of the financial landscape. For those interested in this aspect of finance, understanding the term “bondholder” is crucial. In this comprehensive guide, we will delve into the definition of a bondholder, their role in the financial world, and the intricacies of bond investments. Whether you’re a seasoned investor or just beginning your financial journey, this article will provide you with a clear understanding of what it means to be a bondholder.
What is a bondholder?
A bondholder is an individual or entity that invests in bonds. These bonds are typically issued by corporations and governments to raise capital for various purposes. When bondholders invest in these securities, they are effectively lending money to the bond issuers. In return, bondholders receive their principal or initial investment back when the bonds reach maturity. Additionally, for most bonds, bondholders receive periodic interest payments.
Corporate bonds
Corporate bonds are issued by companies, typically well-established corporations. These bonds are used to raise capital for expansion, research, or other business activities. Unlike government bonds, corporate bonds are considered riskier because they are not backed by the full faith and credit of a government entity. If the issuing company faces financial troubles or bankruptcy, bondholders may face a higher level of risk.
Municipal bonds
Municipal bonds, often referred to as “munis,” are issued by local or state governments. These bonds are used to finance local projects, such as schools, hospitals, or infrastructure development. One significant advantage of municipal bonds is that the interest income is often exempt from federal taxes, making them an attractive option for investors in high tax brackets.
Bondholders in action: Real-world examples
Example 1: U.S. Treasury bonds
A prime illustration of government bonds is U.S. Treasury bonds (T-bonds). These bonds are issued by the U.S. government to raise funds for various purposes. They are considered risk-free because they are backed by the full faith and credit of the U.S. government. However, this safety often comes with lower interest rates compared to corporate bonds.
Example 2: Corporate bonds – Microsoft
Microsoft, a tech giant, issues corporate bonds to raise capital for its operations and expansion. These bonds typically have maturities ranging from a few years to several decades. While corporate bonds may offer higher yields, they come with higher risks, including the potential for a company to face financial difficulties.
Pros and cons
Understanding bondholders
Bondholders purchase bonds directly from the entity that issues them, which can be governments at various levels (federal and local) or corporations. These bonds are sold whenever the issuing entity needs to raise funds for specific purposes, such as funding social programs, infrastructure projects, or corporate expansion.
One of the key attractions of bonds is the promise of the return of the principal investment when the bond reaches its maturity date. Some bonds also promise to pay periodic interest or coupon payments, which can be paid either before or upon maturity.
Bonds are generally considered safer investments compared to stocks because bondholders have a higher claim on the issuer’s assets in case of bankruptcy. In other words, bondholders are more likely to recover their investment before common stockholders in the event of liquidation.
Key considerations for bondholders
Interest rate
The coupon rate represents the interest rate that the company or government pays to bondholders. It can be either fixed or floating, where the latter is often tied to a benchmark, such as the yield of the 10-year Treasury bond.
Some bonds do not pay periodic interest; instead, they are sold at a discount to their face value. For example, a zero-coupon bond doesn’t pay coupon interest but appreciates in value until it returns its full face value at maturity.
Maturity date
The maturity date is crucial for bondholders. This is the date when the issuing entity must repay the principal initial investment to bondholders. Most government securities pay back the principal at maturity. However, corporations that issue bonds have a few options for how they can repay.
The most common form of repayment is called a redemption out of capital, where the issuing company makes a lump sum payment on the date of maturity. Another option is a debenture redemption reserve, where the issuing company returns specific amounts each year until the debenture is repaid on the date of maturity.
Some bonds are callable securities. A callable bond—also known as a redeemable bond—is one that the issuer may redeem before the stated maturity. If called, the issuer will return the investor’s principal early, ending all future coupon payments.
Credit ratings
The issuer’s credit rating and ultimately the bond’s credit rating impact the interest rate that investors will receive. Credit-rating agencies measure the creditworthiness of corporate and government bonds to provide investors with an overview of the risks involved in investing in that particular bond as opposed to investing in similar products.
Credit rating agencies typically assign letter grades to indicate these ratings. Standard & Poor’s, for instance, has a credit rating scale ranging from excellent at AAA to C and D for securities that carry higher credit risk. A debt instrument with a rating below BB is considered to be a speculative-grade or a junk bond, which means the bond’s issuer is more likely to default on loans.
In August 2023, Fitch downgraded the long-term ratings for the United States. The rating dropped from AAA to AA+. Fitch stated the move was due to the increasing national debt and the potential for “fiscal deterioration” over the next three years.
Bondholders earn income
Earned income
Bondholders earn income in two primary ways. First, most bonds return regular interest—coupon rate—payments that are usually paid semi-annually. However, depending on the structure of the bond it may pay yearly, quarterly, or even monthly coupons. For example, if a bond pays a 4% interest
rate, called a coupon rate, and has a $1,000 face value, the investor will be paid $40 per year or $20 semiannually until maturity. The bondholder receives their full principal back at bond maturity ($1,000 x 0.04 = $40 ÷ 2 = $20).
The second way a bondholder can earn income from the holding is by selling the bond on the secondary market. If a bondholder sells the bond before maturity, there’s the potential for a gain on the sale. Like other securities, bonds can increase in value, but several factors come into play with bond appreciation.
For example, let’s say an investor paid $1,000 for a bond with a $1,000 face value. If the bondholder sells the bond before maturity in the secondary market and the bond may fetch $1,050, thereby earning $50 on the sale. Of course, the bondholder could lose if the bond decreases in value from the original purchase price.
Taxation
Besides the upsides of regular passive income and the return of investment at maturity, one significant advantage of being a bondholder is that the income from certain bonds may be exempt from income taxes. Municipal bonds, those issued by local or state governments, often pay interest that is not subject to taxation. However, to purchase a triple-tax-free bond that is exempt from state, local, and federal taxes, you typically must live in the municipality in which the bond is issued.
Rewards and risks for bondholders
Rewards
The rewards available to bondholders include a relatively safe investment product. They receive regular interest payments and a return of their invested principal on maturity. Also, in some cases, the interest is not subject to taxes.
Being a bondholder is generally perceived as a low-risk endeavor when compared to other types of investments, such as stocks. That’s because bonds, which are fixed-income investments, guarantee consistent interest payments and the return of principal at maturity.
In the case of corporate bankruptcies, bondholders are commonly among the first to be reimbursed. Common stockholders, on the other hand, are on the lower rungs of the repayment ladder.
Although there are certain tax implications associated with certain bonds, there are some bond categories that provide holders with tax-free interest payments. This means the investor doesn’t have to declare the interest as income and can net the entire amount as profit.
Risks
The interest rate paid on a bond might not keep up with inflation. Inflationary risk is a measure of price increases throughout an economy. If prices rise by 3% and the bond pays a 2% coupon, the bondholder has a net loss in real terms. In other words, bondholders are susceptible to inflation risk.
Bondholders also must deal with interest rate risk. Interest rate risk occurs when interest rates are rising. Most bonds have fixed-rate coupons, and as market rates rise, they may end up paying lower rates. As a result, a bondholder might earn a lower yield compared to the market in the rising-rate environment.
For example, corporate bonds generally yield higher returns than holding government bonds, but they come with higher risks. This yield difference is because it is less likely a government or municipality will file for bankruptcy and leave its bondholders unpaid. Of course, bonds issued by foreign countries with shakier economies or governments during upheaval can still carry a far greater risk of default than those issued by financially stable governments and corporations.
Bond investors must consider the risk-versus-reward of being a bondholder. Risk causes bond prices on the secondary market to fluctuate and deviate from the bond’s face value. Potential bondholders may not be willing to pay $1,000 for a bond with a $1,000 face value if it’s issued by a new company with little earnings history or by a foreign government with an uncertain future.
As a result, the $1,000 bond may only sell for $800 or at a discount. However, the investor who purchases the bond is taking the risk that the issuer will not fold or default before the investment’s maturity. In return, the bondholder has the potential of a 20% gain at maturity.
Rewards
- Bondholders can earn a fixed income with regular interest—or coupon—payments.
- Safe, risk-free investment with U.S. Treasury options.
- Bondholders receive payment in a corporate bankruptcy before common stock shareholders.
- Some municipal bonds provide tax-free interest payments.
Risks
- Interest rate risk when market rates are rising.
- Credit and default risk can happen to corporate bonds tied to the issuer’s financial viability.
- Inflationary risk if inflation outpaces the bond’s coupon rate.
- A bond’s face value on the secondary market may decrease when market interest rates outpace the coupon rate.
Examples of bondholders
Potential bondholders can invest in government bonds or corporate bonds. Below is an example of each with the benefits and risks.
Government bonds
A U.S. Treasury bond (T-bond) is issued by the U.S. government to raise money to finance projects or day-to-day operations. The U.S. Treasury Department issues bonds via auctions at various times throughout the year while existing bonds trade in the secondary market.
Considered risk-free with the full faith and credit of the U.S. government backing them, T-bonds are a favorite investment for conservative investors. However, the risk-free feature has a drawback as T-bonds usually pay a lower interest rate than corporate bonds.
Treasury bonds are long-term bonds—maturities between 10 to 30 years—providing semiannual interest payments and face values of $1,000. For instance, the 30-year Treasury bond yield closed at 2.817% on March 31, 2019, so the bondholder receives 2.817% yearly. At maturity, in 30 years, they receive the fully invested principal back. T-bonds can sell on the secondary market before maturity.
Corporate bonds
Microsoft (MSFT) has a series of corporate bonds or notes that it issues to raise capital. Many of them are long-term fixed-income assets that mature within 30 years. Issued on Dec. 6, 2013, its maturity date is Dec. 15, 2013, and trades on the secondary market. On Aug. 17, 2023, the bond’s yield was 5.0142%, which means the bondholder gets 5.0142% on an annual basis.
What rights do bondholders have?
There are two inherent rights associated with being a bondholder. The first is to be repaid the full principal amount once the
bond matures. The second is for the bond issuer to pay the bondholder interest at the agreed-upon interval, whether that’s annually, quarterly, or another period.
What’s the difference between a government and corporate bond?
Government bonds are issued by different forms of government, including federal and local governments. Corporate bonds, on the other hand, are issued by companies—usually those that are more established.
Government bonds tend to be considered safer because they are backed by the full faith of the issuing entity, such as those offered by the U.S. government. Corporate bonds, on the other hand, are often deemed a little riskier. Although bondholders are ahead of common stockholders when it comes to being paid, bonds can lose their value if the issuing company goes bankrupt. This means there’s no guarantee how much bondholders will receive.
Can I lose money on a bond?
Yes, there are instances when you can lose money on a bond. Bonds are generally considered safe investments but they are susceptible to certain risks. For instance, inflation can eat away at the returns of a bondholder. If inflation is running higher than what the bond pays, then you’ll lose out. You can also lose money on a bond because of any taxes you may owe on the interest you earn.
The bottom line
Bonds are fixed-income investments that are generally considered safe. Investors who hold bonds are called bondholders. Make sure you know the ins and outs of being a bondholder—notably, things like the interest rate, maturity date, and credit ratings of bond issuers. If you’re reviewing an investment in government or corporate bonds, there are certain factors you should consider. Although they are usually safer than stocks, bonds do come with certain risks, including inflation and interest rate risk.
Bondholders are essential players in the world of finance, providing issuers with the necessary capital to fund various initiatives. Understanding the roles, risks, and rewards associated with being a bondholder is crucial for making informed investment decisions. Whether it’s government bonds, corporate bonds, or municipal bonds, each type has its unique characteristics, and bondholders should carefully consider their choices based on their financial goals and risk tolerance.
Key takeaways
- A bondholder is an individual or entity that invests in bonds issued by corporations or governments, lending money to bond issuers in exchange for interest payments and the return of the principal investment upon maturity.
- Bondholders enjoy regular interest income, creditor status during financial distress, potential for capital gains, and, in some cases, tax advantages, such as tax-free interest on municipal bonds.
- Risks include credit risk (issuer default), interest rate risk (lower yields due to rising rates), inflationary risk, and the potential to lose money if selling bonds below the purchase price.
- To become a bondholder, you can purchase bonds directly from issuers or through brokerage accounts and financial institutions that offer bond investments.
- Bondholders can lose money if the issuer defaults, inflation outpaces returns, or bonds are sold at a lower value. Some bonds may also have tax implications.
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