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INVESTMENT FUNDAMENTALS Bonds 101. What is a bond, and how does bond investing work? © 2023 SEI Footer. 1 What is a bond? When a company or government entity needs money to help fund day-to-day operations or finance certain projects, they issue debt in the form of bonds. Investors who purchase bonds are essentially making a loan to the bond issuer. In exchange, the issuer pays the investor periodic interest payments until the bond becomes due at a specified date in the future. At that point, the issuer pays back the face value of the bond in full to the investor. How does bond investing work? The bond issuer promises to pay the investor a specified rate of interest during the life of the bond and to repay the face value of the bond (typically $1,000) when it matures. Why do people invest in bonds? Investors generally purchase bonds as a way to capture a steady income stream from the bond's coupon payments (with the exception of zero-coupon bonds.) What risks are associated with investing in bonds? Just as bond ownership may offer potential benefits, it also comes with a variety of risks, including but not limited to: • Credit risk: The bond issuer is unable to make payments on time. • Interest rate risk: Bonds and bond funds will decrease in value as interest rates rise. • Liquidity risk: The bondholder will not be able to sell the bond as quickly as desired. • Prepayment risk: If a bond is repaid early, the bondholder receives their principal earlier than expected, which creates a loss of interest income. • Default risk: The bond issuer defaults on payments and thus, the bondholders do not get some (or all) of their money back. Speaking of default risk, there are several agencies that evaluate the creditworthiness of bond issuers and rate them based on the likelihood of default. The three best-known ratings firms are Standard & Poor's (S&P), Moody's, and Fitch. Below is a breakdown of the ratings each agency assigns to bond issuers, and how those ratings translate to the issuer's likelihood of default. Bond Ratings Moody's S&P/Fitch Grade Risk Aaa AAA Investment Highest Quality Aa AA Investment High Quality A A Investment Strong Baa BBB Investment Medium Grade Ba, B BB, B Junk Speculative Caa, Ca, C CCC/CC/C Junk Highly Speculative C D Junk In Default