Owning Bonds

Key Takeaways

• All bonds expose investors to

  • default risk (the risk that coupon and principal payments won't be made),
  • reinvestment risk (the risk that coupon payments will be reinvested at lower rates),
  • interest rate risk (the risk that changing interest rates will affect bond values),
  • inflation risk, (the risk that inflation will devalue bond coupons and principal repayment).

• Bond returns can be measured by yields.

  • The current yield measures short-term return on investment.
  • The yield to maturity measures return on investment until maturity.
  • The holding period yield measures return on investment over the term that the bond is held.
• There is a direct relationship between interest rates and bond yields.
• There is an inverse relationship between bond yields and bond prices (market values).
• There is an inverse relationship between bond prices (market values) and interest rates.
• The yield curve illustrates the term structure of interest rates, showing yields of bonds with differing maturities and the same default risk. The purpose of a yield curve is to show expectations of future interest rates.

• The yield curve may be

  • upward sloping, indicating higher future interest rates;
  • flat, indicating similar future interest rates; or
  • downward sloping, indicating lower future interest rates.