SNAPSHOT: Traditional Coupon Bond and Its Pros and Cons
How It Works:
Traditional bonds are contractual debt obligations having original maturity of ten years or longer. When you hold or own a bond, you hold the debt of a company, a municipality, or a government. You are the lender and in return for making the loan, you are paid interest. The principal and final interest rate are due upon maturity—that’s the date at which a debt instrument is due and payable. Traditional bonds have a fixed interest rate (still called a “coupon” although electronic bookkeeping has made physical coupons obsolete) determined by market conditions at the time of issue, the issuer’s credit quality, and the term to maturity.
Bonds will almost always pay more than the rate bank CDs and money market funds are paying at the time you buy them. Bonds typically have a face (“par”) value of $1,000 at which they are redeemable at maturity, and pay interest semiannually.
You can purchase bonds individually or invest in them via bond funds.
- Relative Safety: You can be fairly certain that interest will be paid as scheduled and the face value of principal will be repaid at maturity. Bond contracts, called bond agreements or indentures, have provisions aimed at keeping the financial condition of issuers strong enough to make the payments required.
- Higher Yield: Bonds offer better yields than certificates of deposit or money market funds.
- First in Line: As creditors, bondholders have a claim on assets that puts them ahead of stockholders in the unlikely event of default.
- Interest Rate Risk. Fixed-rate bonds have the risk that their market value will be lower than face value if they are sold prior to maturity when interest rates are rising.
- Call Risk: If the issuer redeems the bond before maturity, exercising a call provision in the bond contract, you get your principal back, but lose the opportunity for future interest income.
- Reinvestment Risk: This is the possibility that rates will be lower when you reinvest interest payments or the proceeds from redemption. Bond portfolios with staggered or laddered maturities mitigate this risk. Zero coupon bonds lock in the rate at which interest is compounded.
Who Should Invest:
Individuals seeking safety of income and yields higher than bank CDs or money market funds, and who are able to accept interest rate risk.