Corporations and the government issue bonds when they need to raise money for projects or day-to-day operations. The bond is a debt security and is issued for a certain time period. When you purchase a bond, you’re essentially loaning the issuer a specific amount of money (the face value or par value) for a certain period of time. The bond pays interest every year and then pays back the principle at maturity. Corporations, municipalities, and the government typically issue bonds. Bonds are often considered a safer investment than stocks because they’re not as volatile and take priority when it comes to liquidation.
A fixed rate bond pays a set interest rate, or yield, over a period of time. Because the rate is fixed, the investor knows exactly what interest payment (coupon payment) to expect. The coupon payment is the interest payment that’s made each period. A $1,000 10-year fixed-rate bond at 5% interest rate would pay out $50 in interest each year or $25 twice a year.
By contrast, a floating rate bond has a variable interest rate. The interest rate typically adjusts every six months based on another market index. Bonds with floating interest rates are attractive to investors who want to protect themselves against changes in interest rates. However, bonds with floating rates usually have lower yields than similar fixed rate bonds.
Disadvantages of Fixed Rate Bonds
The downside of investing in a fixed rate bond is that your interest rate is set for the duration of the bond. If market interest rates go up and similar bonds have higher interest rates, thus higher coupons, you’re stuck with your rate and the value of your bond goes down. If you wanted to sell your bond to another investor, you’d have to do so at a discount so the new buyer receives the same interest rate on their investment. For example, if you purchase a $10,000 bond paying 4%, the annual bond payment is $400.
If market rates go up to 5%, a buyer has no incentive to purchase your bond for 4% bond for $10,000. Instead, you’ll have to lower the price of your bond to $8,000 so the buyer gets a 5% yield ($400 / .05).
Conversely, if the market rates go down, your bondbecomes more valuable and you can sell it for a premium. This is the ideal situation for an investor who wants to profit from fixed-rate bonds.
Market rate changes aren’t as critical if you’re buying bonds with the expectation that you’ll hold them until maturity. In that case, your main concern is that the bond issuer doesn’t default on the payments. Investors who buy bonds that they later plan to sell are more concerned about changes within interest rates since market changes impacts their ability to sell the bonds for a higher price later on.
Fixed rate bonds aren’t adjusted for inflation, which gives you less purchasing power with your coupon payments. The rates on floating rate bonds are periodically adjusted to keep up with inflation.
With all bonds, there’s the risk that the company who issued the bond might default on the payments. Before you purchase a bond, check the company’s rating with a credit rating agency like Standard & Poor’s, Moody’s, and Fitch Ratings. Companies with a high rating have a low likelihood of defaulting on the note. However, companies with low ratings have questionable repayment ability. Bonds issued by low-rated companies may advertise higher interest rates to attract investors. Take caution investing in these bonds.
You may have to pay taxes on the interest you receive from certain bonds, this includes U.S. Treasury bonds, corporate bonds, and zero coupon bonds which don’t pay the interest until maturity. Municipal bonds are tax-free as long as you purchase them in the city and state that you live. The amount of tax you have to pay depends on your tax bracket and other deductions. A tax professional can help you figure out the specific tax implications from your fixed-rate bond payments.