Debt securities are a way for organizations to raise money without offering equity. When fundraising via debt, companies and governments issue bonds. Bonds are promissory notes that entitle the holder to repayment of the principal loan amount and any interest specified by the bond. They’re loans taken out through public markets, instead of through private institutions like banks. The person holding the bond is the bondholder.
Bondholders are investors because the securities they hold offer the promise of future return. Whether they recoup the par value of the bond at its maturity date or collect interest payments over the bond’s term, there’s incentive for these investors to lend money. Becoming a bondholder also opens the door to certain investment strategies, such as fixed-income investing or hedging against the volatility of equities.
Here’s what it means to be a bondholder and the implications that come with owning debt securities, no matter who issues them.
How to Become a Bondholder
To become a bondholder, you need to purchase debt. There are several ways to do this, with the easiest being either direct from the issuer or through secondary markets.
If you decide to buy bonds directly from the debt issuer, prepare to pay the full par value of the bond. You’ll need to look to the following issuers:
- Municipal bonds finance public works projects.
- U.S. Treasury bonds support federal government projects.
- Corporate bonds help companies fund expansion.
In fact, buying bonds directly from the issuer often comes with specific implications. You can only buy bonds as they’re offered and usually, in specified quantities. As a result, institutions are typically the biggest purchasers of bonds directly from issuers.
Most retail investors become bondholders through secondary markets. This is where individual bonds trade at a premium or discount relative to current market interest rates. While the par value and coupon rate of bonds don’t change, their relative value and remaining term both do. Secondary markets are where prospective bondholders come to find bonds that fit their investing strategy or timeline.
Why Become a Bondholder?
Investors become bondholders for two primary reasons: to earn income and to hedge against risk. Bonds are traditionally stable investments compared to stocks and other equities, which makes them easier to predict and manage. This makes them great for more conservative investors. Here’s a look at some of the chief reasons bonds attract investors:
- Passive income. Most bonds offer coupon payments over the term of the bond, paid directly to investors as a form of income.
- Fixed variables. While market rates for bonds may change, par values and coupon rates remain fixed. This allows for a measure of predictability from bonds.
- Credit ratings. Bonds come with credit ratings that help investors determine risk. This helps them better-understand the implications of debt securities.
- Active market. Bonds trade in secondary markets, allowing investors to access desired bond types with relative ease.
- Tax advantaged. Many municipal bonds are exempt from taxes, which increase their profitability and offset other capital gains.
- Payment surety. In the event of company bankruptcy, bondholders receive payment before stockholders with common shares.
Stability, predictability and transparency are the core pillars of bond investments. Investors seeking passive income, safeguards against volatility and long-term positioning will find themselves drawn to bonds.
The Risks of Becoming a Bondholder
Bondholders often see debt investments as a “safe” play when compared to the stock market. However, bonds aren’t without risk. Investing in debt can have its own pitfalls and struggles, which can lead to complicated problems that disrupt more conservative investment strategies. For example, here’s what bondholders need to watch out for.
- Changing rates. Interest rates constantly change. As longer-term investments, bonds face interest rate risk when current market rates devalue the rates of existing bonds.
- Default risk. Buying bonds with less-than-superior ratings opens the door to default risk, in which bondholders aren’t able to recoup their investment.
- Inflationary risk. If a bond’s yield doesn’t pace or beat inflation, bondholders could find themselves losing money on their investment long-term.
- Opportunity cost. Bonds traditionally see far lesser returns than stocks over comparable time periods, which means investors aren’t maximizing their potential for ROI.
Bondholders have much less risk and volatility to worry about vs. stockholders, but lower risk also means lower reward. If you’re interested in bonds, make sure they’re a good fit for your investment strategy first.
Who Should Invest in Bonds?
While anyone can become a bondholder by purchasing debt securities, these investments are best-reserved for those seeking to execute specific strategies:
- Fixed or passive income. These investors ladder bonds to create a steady stream of reliable income, distributed via coupon payments.
- Retirees and seniors. Those reliant on their portfolios to sustain them through their retirement years will appreciate the stability of bonds. Fixed income is also a bonus.
- Balanced investors. These investors will allocate a small portion of their portfolio to bonds as a way to hedge against volatility and mitigate risk.
- Institutions. Insurance companies and banking institutions tend to invest heavily in bonds due to their stable nature and reliable coupon payments.
To capitalize as a bondholder, you need to have an investment strategy that’s specific to bonds. Therefore, find ways to leverage the stability and certainty of bonds into a portfolio that behaves as you expect it to.
Should You Become a Bondholder?
In the world of investments, bonds fall to the more conservative, stable end of the spectrum. However, they’re great for long-term outlooks and individuals seeking passive income, who don’t want to worry about the everyday up and down that accompanies equity investments.
Remember that beyond just buying bonds, the type of bond matters. Consider the issuer, the coupon rate, the term and other variables, and understand how they’re affected by external market forces. As is the case with any asset, being a bondholder comes down to understanding exactly what you’re investing in.