Bond Basics

Robillard · 05-22-2009, 10:35 PM

In the thread on the explanation of the national debt, forum member byron84 asked some fundamental questions about bonds. In this post, I will try to clarify some of the basic terminology and mechanics of how bonds work. If I make any mistakes, please correct me.

A bond is basically a big loan broken up into tiny identical pieces. When a corporation or government wants to raise a lot of money in the capital markets, they can issue bonds and sell them to investors. A bond is a legal obligation in which the borrower agrees to pay coupons to the investors at fixed intervals until the bond matures. On the date that the bond matures, the borrower will redeem the bond and pay the investor the face value of the bond. The redemption of the bond ends the legal obligation of the borrower to the investor. Unless the bond has an embedded call option, bonds cannot be redeemed by the issuer prior to the maturity date.

Bonds can be very complicated instruments, since issuers and their advisors (investment banks) can tailor the suit their needs and those of the market. In the most basic type of bond, there are key characteristics as follows:

Maturity date - As was described above, this is the date that the bond issuer agrees to redeem the bonds and pay the face value to the bondholder. Typically it is also the date of the last coupon payment.

Face value - These days bonds are no longer issued as physical paper certificates, but in the olden days, every bond certificate had amount printed on it that indicated the amount of money the bond issuer agreed to pay the investor on the maturity date. It is common practice in North America these days for the face value of a bond to be in $1000 increments.

Coupon - In olden days, bonds had perforated sections referred to as coupons that could be torn off and redeemed for the agreed amount of coupon payment; these days this is all done electronically.

Coupon rate - The coupon rate is the ratio of coupon payment to the face value of the bond a 5% coupon bond with a face value of $1000 will make annual coupon payments of $50 during the year.

Coupon frequency - This is the number of times that coupon payments are made during the year. By tradition, in North America most bonds make two coupon payments per year. A $1000 face value bond with a 5% coupon rate making two payments per year will pay $25 twice a year at 6 month intervals. Not all bonds have the same coupon frequency though!

Yield-to-maturity and purchase price - I have put these two together because they are intimately related. The yield-to-maturity is the discount rate that is applied to all the future cash flows of the bond to determine the price. The yield-to-maturity represents the return the investor will earn assuming that the bond is held to maturity, that all coupon payments are reinvested at an equivalent interest rate, and that the bond issuer does not default. The price at purchase is the present value of all the remaining coupon payments and the face value discounted at the yield-to-maturity. The mathematics of discounting cash flows are best described elsewhere for now.

Yield and price - More generically, you might hear people talk about bond yields. The yield on the open market represents the lowest return that investors are willing to accept from purchasing that bond issue. The price of a bond on the open market is is equal to the present value of the future payments of the bond (coupons and face value) discounted at the prevailing yield for that bond issue. When the yield is equal to the coupon rate, then the bond price is simply equal to its face value (referred to as trading at par value). When the yield is above the coupon rate, the bond is trading at a discount, meaning that the current price is less than face value. When the yield is below the coupon rate, the bond is trading at a premium, meaning that the current price is above face value. Bond yields are influenced by a number of factors including prevailing interest rates, the creditworthiness of the bond issuer (i.e. expectation of default), and relative demand for bonds compared to other investments.

If you go to your investment advisor and inquire about purchasing a bond, they will probably call their institution's bond trading desk and ask at what price and yield the bond issue is being offered. Incidentally, bonds are traded in the over-the-counter market, between bond dealers, banks and other market participants - as opposed to stocks which are traded on relatively centralised exchanges. If you agree to purchase the bond at the quoted price and yield, then the bond trading desk will purchase the bond on the open market and place it in your brokerage account. The minimum amount of a bond purchase in Canada is typically $5000 of face value (if the bond is trading at a discount, then the purchase price will obviously be less than $5000) and in $1000 increments. Bond prices are usually quoted as an amount per $100 of face value. So a bond offered at 102 is trading at a premium, and the minimum purchase would be $5100.

If you purchase a bond between coupon payment dates, you will also have to pay for the accrued interest on the bond. Coupon payments are accrued daily until they are paid out on the specified payment date(s). The amount of accrued interest on the bond can be determined mathematically by taking the coupon payment amount, dividing it by the number of days that it accrues (for a bond with 2 coupon payments per year, this should be about 182.5 days) and multiplying by the number of days since the last payment. So for example, if you want to purchase $5000 in face value of bonds that pay 5% in coupons twice a year, and the bond is currently offered at 102, then you have to pay between $5100 and $5225 depending upon when the last coupon payment was made.

Selling a bond (prior to maturity) has a similar mechanic to purchasing a bond. If you tell your investment advisor you want to sell your bonds, they will call the bond trading desk, which will quote a bid price and yield. Using the example above, suppose you bought the bond quoted at 102 for about $5100 (on day after the last the coupon payment date). 9 months have passed, and you received one coupon payment of $125 in the interim. bond yields fell during this time and now your investment advisor says that the bond is being bid at 104. In this situation, when you sell the bond, you receive $5200 plus the amount of accrued interest (which should be about $62.50). The difference in prices of $100 is taxable as a capital gain, while the $125 coupon payment and $62.50 accrued interest are taxable as interest income.

OntFA · 05-25-2009, 09:43 PM

A few practical tips on bonds:

Don't buy a bond directly unless you plan to hold it until maturity. Otherwise, you could get taken to the cleaners on embedded trading costs.

Also, most individual investors are best to buy strip bonds so that you don't have small interest or coupon payments to reinvest - which is hard to do in a cost effective way.

On that note, the yield to maturity is a bit mythical since you can only realize that by reinvesting all of your coupons at the YTM with no cost so it's an indication of the yield available to you but the only way for you to get the full YTM or higher is if yields rise as you 'clip your coupons'.

Stick to high quality (government of Canada or a province).

If you want to go into something like corporate bonds stick to a fund or ETF and limit that to no more than 1/3 or so of your total allocation to bonds.

tojo · 05-26-2009, 10:54 AM

Quote:

Originally Posted by OntFA

A few practical tips on bonds:

Stick to high quality (government of Canada or a province).

If you want to go into something like corporate bonds stick to a fund or ETF and limit that to no more than 1/3 or so of your total allocation to bonds.

Would any of you gentlemen know the best way to purchase decent quality corporate bonds. I don't have the resources, going through my discount broker...the buy/sell spreads are a rip-off, and it appears the juicy yields from a few months ago are no more. For example, I do see "LOBLAWS MTN CANADA CALLABLE" coupon 6.45%, listed at a discount sell yield 7.88%, buy yield 7.49% maturing 03/01/2039 (that's a long time from now!). Would you trust a name like this, rated BBBm (DBRS)? I've resorted to PH&N High Yield Bond Fund and Bond Index funds, - but I hate paying the MER. Thanks.

OntFA · 05-26-2009, 12:16 PM

Quote:

Originally Posted by tojo

Would any of you gentlemen know the best way to purchase decent quality corporate bonds. I don't have the resources, going through my discount broker...the buy/sell spreads are a rip-off, and it appears the juicy yields from a few months ago are no more. For example, I do see "LOBLAWS MTN CANADA CALLABLE" coupon 6.45%, listed at a discount sell yield 7.88%, buy yield 7.49% maturing 03/01/2039 (that's a long time from now!). Would you trust a name like this, rated BBBm (DBRS)? I've resorted to PH&N High Yield Bond Fund and Bond Index funds, - but I hate paying the MER. Thanks.

You will pay one way or another. Take a look at ETFs by iShares and Claymore for the cheapest corporate bond exposure. Otherwise, the PH&N fund is a great one too. I would not advise anyone, even with six figures, buy corporate bonds directly. As you admit yourself, the spreads are a great deal for the bond desk but not for you. Remember too, with funds, you'll have an easier time reinvesting the relatively larger interest payments offered today.

tojo · 05-26-2009, 01:06 PM

Quote:

Originally Posted by OntFA

You will pay one way or another. Take a look at ETFs by iShares and Claymore for the cheapest corporate bond exposure. Otherwise, the PH&N fund is a great one too. I would not advise anyone, even with six figures, buy corporate bonds directly. As you admit yourself, the spreads are a great deal for the bond desk but not for you. Remember too, with funds, you'll have an easier time reinvesting the relatively larger interest payments offered today.

the bond market is not designed for the retail investor like us....very unfair...I'll take your advice - have enough on my hands with maintaining my pref portfolio - and stick with low cost bond funds. Thanks!

Robillard · 05-27-2009, 01:00 AM

tojo,
The issue you mentioned does mature in 2039, but since that issue is callable, there is a reasonable probability that the issuer will call the bond prior to maturity. If you want to find more information about a specific issue, you can try looking for the prospectus on SEDAR, which is a repository of public company documents. Incidentally you can also find information on investment fund companies here.

As for the spread, yes, the spreads are wide. I wouldn't be surprised if bonds spreads were wider in Canada than the US. Certainly bond spreads are wider than stock price spreads, especially on long-term bonds, but when you consider the costs of executing stock trades in comparison to the spreads on bond yields, they are fairly comparable if you are comparing against short term bonds. Consider Royal Bank of Canada's issue 4.97% coupon issue that matures on June 5, 2014. My discount broker is quoting a bid at 105.419 and an offer at 106.851 (the associated yields are bid at 3.77454%, offered at 3.47076%). A $5000 face value purchase would cost $5342.55 (ignoring accrued coupon interest). A seller would receive $5270.95 (ignoring accrued coupon interest). That puts the spread at $71.60. If you compare that against the cost of executing a buy and sell on a stock at anywhere from $10 to $40 per trade, plus a per share amount, in addition to the built in spread in the market (spreads on low-volume TSX issues can be a lot wider than 1 cent per share). So you see, the bond spreads are not necessarily much worse than an expensive discount broker's execution costs for stocks. Long term bonds have wider spreads than short term bonds though.

leslie · 05-27-2009, 07:57 AM

I agree that bond market is not set up for retail investors, except to rip us off. I buy exchange traded debt instead - prefs and debentures. They also have their problems, but they beat being held at gunpoint by our brokers.

tojo · 05-27-2009, 08:43 PM

Quote:

Originally Posted by Robillard

tojo,
Consider Royal Bank of Canada's issue 4.97% coupon issue that matures on June 5, 2014. My discount broker is quoting a bid at 105.419 and an offer at 106.851 (the associated yields are bid at 3.77454%, offered at 3.47076%). A $5000 face value purchase would cost $5342.55 (ignoring accrued coupon interest). A seller would receive $5270.95 (ignoring accrued coupon interest). That puts the spread at $71.60.

Robillard,

Brookfield came out with a new issue today. I've pasted some details below. I admit I don't know much about this type of fixed income, but what would you consider as the risks in holding such a product. I hold a few pref issues from them, but nothing like the below....the terms seem much more attractive than on the fixed income board. Thanks in advance...

Note: I see the minimum quantity is a bit high! Which will prevent me from buying it as a new issue - it closed fast anyways.

Brookfield Asset Management 8.95% Senior Unsecured Notes 02Jun14
Short Description: Offering of Unsecured Notes
Size of Issue: $500-million
Category: Fixed Income
Price: $99.802 CDN per $100 par value
Coupon: 8.95 % per annum paid semi-annually
Coupon Frequency: Semi-annually
Yield To Maturity: 9.00% semi-annual; 9.20% annual
Spread 649.6 basis points above the yield of the Government of Canada 3.00% June 2014
Maturity: Jun 02, 2014
Settlement Date: June 2, 2009
RSP Eligible: Yes
RSP Content Domestic
Lot Size: 1,000
Min. Quantity: 5,000
Max. Quantity: 50,000
Ratings: DBRS: A S&P: A- Moody's: Baa2

Robillard · 05-27-2009, 11:52 PM

Tojo,
The key risks for in most bond issues are the same. They consist of interest rate risk, reinvestment risk, inflation risk, default risk and credit rating risk (this could also be called downgrade risk). There are risks relating to the shape of the yield curve, but that might be too complex to discuss at this point.

All bonds with fixed coupons are exposed to interest rate risk. Basically, when interest rates for bonds with a similar maturity increase, bond yields rise, and thus the price falls. If the Bank of Canada raises the target overnight lending rate by 25 basis point, this does not exactly translate into the same increase in the yields on all bonds. Some, particularly long term issues, might be totally unaffected, but short term issues are definitely affected. In general though, increases in interest rates are almost universally decrease the value of bonds.

Reinvestment risk has to do with the problem of reinvesting coupon payments. When you buy bonds, you purchase them at a set yield-to-maturity, which is the expected return you would earn if you were able to reinvest each coupon payment at the same yield rate. Unfortunately, there is no such thing as DRIPs on bonds. As such, there is no way to guarantee you will actually realise the yield-to-maturity since you don't know at what interest rate you will be able to reinvest the coupon payments.

Inflation risk has to do with the risk that inflation rises and decreases the purchasing power of your investment. When inflation increases, bond yields tend to increase (driving down bond prices) because new investors demand compensation the the expected decrease in the real return that the bond will yield. If inflation is increasing prices at 2% per year, then a 6% nominal yield on a bond is really only yielding a real return of about 4%. While stocks prices have a tendency to keep pace with inflation because corporations tend to increase dividends to keep pace, bond returns get clobbered by inflation since in most cases the coupon payments and the repayment at maturity are fixed.

Default risk is simply the risk that the issuer is unable to pay the coupon interest payments or repay the face value at maturity and goes bankrupt. In bankruptcy though, bondholders tend to fare better than shareholders because bondholders have a higher priority claim on a company's assets than the shareholders. Senior issues backed by specific collateral have the lowest default risk, while subordinated unsecured issues have the highest risk (which is still lower than the risk to the common shareholders). Long term bonds have more default risk than short term bonds.

Related to default risk is credit rating risk. Credit rating agencies usually provide an issue-specific rating on a bond when it is issued, and then continue watching the company to ensure that its ability to make coupon payments and repay at maturity isn't changing. If a credit rating agency things a company's ability to service its debts is deteriorating, it will put it on watch for a credit rating downgrade. If the credit rating does get downgraded, then the bond yields demanded in the market for that issue will rise. Of course, a downgrade doesn't affect the investor's ability to realise the yield-to-maturity so long as the issuer can continue to make coupon payments and repay at maturity. It does affect the investor's ability to sell the bond and break even though. Take the Brookfield issue as an example. Suppose you bought part of this issue and soon afterwards S&P cut the credit rating on the issue from A- to BBB. This would cause the yield demanded in the market to increase above the 9.00% at which you bought the issue. As long as Brookfield can continue to service its debts, your ability to realise that 9% return is not in much jeopardy (keeping in mind what I already said about reinvestment risk), but if you try to sell your bonds, you will probably get less than what you paid for them.

As for what you said about the terms of the new issue being more attractive than those currently on the market. This is an illusion. The fact is, that a spread is already built in to the price. The institutions in the bond underwriting syndicate might have only paid Brookfield $99.00 for $100 of face value, and then sold most of the issue to the selling group members of the syndicate at $99.50 for $100 of face value. The selling group members then go and sell to investors at say, $99.75 for $100 of face value. There is no getting around this; an investors can't buy the issue at $99.00, which was the price that the syndicate members paid. Individual investors probably get the worst deal, as large volume purchasers, such as mutual funds, may be able to negotiate a better price than $99.75 with the selling group.

Really, I wouldn't read too much into the width of the bid/offer spread on the market. If I was going to hold a bond to maturity, I wouldn't be too concerned with the bids of bond dealers. Bonds are not meant for frequent trading (arguably, neither are most stocks). If you buy and sell bonds a lot, the bid/offer spread can be a profit killer; so don't do it. At the same time though, bonds aren't just about interest income. If you expect interest rates or credit spreads (roughly the spread between the bond's yield and the yield of a risk-free government bond with close to the same maturity date) to fall, then you might be able to sell prior to maturity and net a healthy capital gain.

tojo · 05-28-2009, 05:58 AM

Quote:

Originally Posted by Robillard

Tojo,
The key risks for in most bond issues are the same. They consist of interest rate risk, reinvestment risk, inflation risk, default risk and credit rating risk (this could also be called downgrade risk). There are risks relating to the shape of the yield curve, but that might be too complex to discuss at this point.

Robillard, your detailed response is informative and very much appreciated. I have a better understanding of bonds now

.

05-22-2009, 10:35 PM	#1
Robillard Senior Member Join Date: Apr 2009 Location: Vancouver, BC Posts: 175	Bond Basics In the thread on the explanation of the national debt, forum member byron84 asked some fundamental questions about bonds. In this post, I will try to clarify some of the basic terminology and mechanics of how bonds work. If I make any mistakes, please correct me. A bond is basically a big loan broken up into tiny identical pieces. When a corporation or government wants to raise a lot of money in the capital markets, they can issue bonds and sell them to investors. A bond is a legal obligation in which the borrower agrees to pay coupons to the investors at fixed intervals until the bond matures. On the date that the bond matures, the borrower will redeem the bond and pay the investor the face value of the bond. The redemption of the bond ends the legal obligation of the borrower to the investor. Unless the bond has an embedded call option, bonds cannot be redeemed by the issuer prior to the maturity date. Bonds can be very complicated instruments, since issuers and their advisors (investment banks) can tailor the suit their needs and those of the market. In the most basic type of bond, there are key characteristics as follows: Maturity date - As was described above, this is the date that the bond issuer agrees to redeem the bonds and pay the face value to the bondholder. Typically it is also the date of the last coupon payment. Face value - These days bonds are no longer issued as physical paper certificates, but in the olden days, every bond certificate had amount printed on it that indicated the amount of money the bond issuer agreed to pay the investor on the maturity date. It is common practice in North America these days for the face value of a bond to be in $1000 increments. Coupon - In olden days, bonds had perforated sections referred to as coupons that could be torn off and redeemed for the agreed amount of coupon payment; these days this is all done electronically. Coupon rate - The coupon rate is the ratio of coupon payment to the face value of the bond a 5% coupon bond with a face value of $1000 will make annual coupon payments of $50 during the year. Coupon frequency - This is the number of times that coupon payments are made during the year. By tradition, in North America most bonds make two coupon payments per year. A $1000 face value bond with a 5% coupon rate making two payments per year will pay $25 twice a year at 6 month intervals. Not all bonds have the same coupon frequency though! Yield-to-maturity and purchase price - I have put these two together because they are intimately related. The yield-to-maturity is the discount rate that is applied to all the future cash flows of the bond to determine the price. The yield-to-maturity represents the return the investor will earn assuming that the bond is held to maturity, that all coupon payments are reinvested at an equivalent interest rate, and that the bond issuer does not default. The price at purchase is the present value of all the remaining coupon payments and the face value discounted at the yield-to-maturity. The mathematics of discounting cash flows are best described elsewhere for now. Yield and price - More generically, you might hear people talk about bond yields. The yield on the open market represents the lowest return that investors are willing to accept from purchasing that bond issue. The price of a bond on the open market is is equal to the present value of the future payments of the bond (coupons and face value) discounted at the prevailing yield for that bond issue. When the yield is equal to the coupon rate, then the bond price is simply equal to its face value (referred to as trading at par value). When the yield is above the coupon rate, the bond is trading at a discount, meaning that the current price is less than face value. When the yield is below the coupon rate, the bond is trading at a premium, meaning that the current price is above face value. Bond yields are influenced by a number of factors including prevailing interest rates, the creditworthiness of the bond issuer (i.e. expectation of default), and relative demand for bonds compared to other investments. If you go to your investment advisor and inquire about purchasing a bond, they will probably call their institution's bond trading desk and ask at what price and yield the bond issue is being offered. Incidentally, bonds are traded in the over-the-counter market, between bond dealers, banks and other market participants - as opposed to stocks which are traded on relatively centralised exchanges. If you agree to purchase the bond at the quoted price and yield, then the bond trading desk will purchase the bond on the open market and place it in your brokerage account. The minimum amount of a bond purchase in Canada is typically $5000 of face value (if the bond is trading at a discount, then the purchase price will obviously be less than $5000) and in $1000 increments. Bond prices are usually quoted as an amount per $100 of face value. So a bond offered at 102 is trading at a premium, and the minimum purchase would be $5100. If you purchase a bond between coupon payment dates, you will also have to pay for the accrued interest on the bond. Coupon payments are accrued daily until they are paid out on the specified payment date(s). The amount of accrued interest on the bond can be determined mathematically by taking the coupon payment amount, dividing it by the number of days that it accrues (for a bond with 2 coupon payments per year, this should be about 182.5 days) and multiplying by the number of days since the last payment. So for example, if you want to purchase $5000 in face value of bonds that pay 5% in coupons twice a year, and the bond is currently offered at 102, then you have to pay between $5100 and $5225 depending upon when the last coupon payment was made. Selling a bond (prior to maturity) has a similar mechanic to purchasing a bond. If you tell your investment advisor you want to sell your bonds, they will call the bond trading desk, which will quote a bid price and yield. Using the example above, suppose you bought the bond quoted at 102 for about $5100 (on day after the last the coupon payment date). 9 months have passed, and you received one coupon payment of $125 in the interim. bond yields fell during this time and now your investment advisor says that the bond is being bid at 104. In this situation, when you sell the bond, you receive $5200 plus the amount of accrued interest (which should be about $62.50). The difference in prices of $100 is taxable as a capital gain, while the $125 coupon payment and $62.50 accrued interest are taxable as interest income.

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05-25-2009, 09:43 PM	#2
OntFA Member Join Date: May 2009 Location: Ontario Posts: 94	A few practical tips on bonds: Don't buy a bond directly unless you plan to hold it until maturity. Otherwise, you could get taken to the cleaners on embedded trading costs. Also, most individual investors are best to buy strip bonds so that you don't have small interest or coupon payments to reinvest - which is hard to do in a cost effective way. On that note, the yield to maturity is a bit mythical since you can only realize that by reinvesting all of your coupons at the YTM with no cost so it's an indication of the yield available to you but the only way for you to get the full YTM or higher is if yields rise as you 'clip your coupons'. Stick to high quality (government of Canada or a province). If you want to go into something like corporate bonds stick to a fund or ETF and limit that to no more than 1/3 or so of your total allocation to bonds.

05-27-2009, 01:00 AM	#6
Robillard Senior Member Join Date: Apr 2009 Location: Vancouver, BC Posts: 175	tojo, The issue you mentioned does mature in 2039, but since that issue is callable, there is a reasonable probability that the issuer will call the bond prior to maturity. If you want to find more information about a specific issue, you can try looking for the prospectus on SEDAR, which is a repository of public company documents. Incidentally you can also find information on investment fund companies here. As for the spread, yes, the spreads are wide. I wouldn't be surprised if bonds spreads were wider in Canada than the US. Certainly bond spreads are wider than stock price spreads, especially on long-term bonds, but when you consider the costs of executing stock trades in comparison to the spreads on bond yields, they are fairly comparable if you are comparing against short term bonds. Consider Royal Bank of Canada's issue 4.97% coupon issue that matures on June 5, 2014. My discount broker is quoting a bid at 105.419 and an offer at 106.851 (the associated yields are bid at 3.77454%, offered at 3.47076%). A $5000 face value purchase would cost $5342.55 (ignoring accrued coupon interest). A seller would receive $5270.95 (ignoring accrued coupon interest). That puts the spread at $71.60. If you compare that against the cost of executing a buy and sell on a stock at anywhere from $10 to $40 per trade, plus a per share amount, in addition to the built in spread in the market (spreads on low-volume TSX issues can be a lot wider than 1 cent per share). So you see, the bond spreads are not necessarily much worse than an expensive discount broker's execution costs for stocks. Long term bonds have wider spreads than short term bonds though.

05-27-2009, 07:57 AM	#7
leslie Senior Member Join Date: May 2009 Posts: 376	I agree that bond market is not set up for retail investors, except to rip us off. I buy exchange traded debt instead - prefs and debentures. They also have their problems, but they beat being held at gunpoint by our brokers.

05-27-2009, 11:52 PM	#9
Robillard Senior Member Join Date: Apr 2009 Location: Vancouver, BC Posts: 175	Tojo, The key risks for in most bond issues are the same. They consist of interest rate risk, reinvestment risk, inflation risk, default risk and credit rating risk (this could also be called downgrade risk). There are risks relating to the shape of the yield curve, but that might be too complex to discuss at this point. All bonds with fixed coupons are exposed to interest rate risk. Basically, when interest rates for bonds with a similar maturity increase, bond yields rise, and thus the price falls. If the Bank of Canada raises the target overnight lending rate by 25 basis point, this does not exactly translate into the same increase in the yields on all bonds. Some, particularly long term issues, might be totally unaffected, but short term issues are definitely affected. In general though, increases in interest rates are almost universally decrease the value of bonds. Reinvestment risk has to do with the problem of reinvesting coupon payments. When you buy bonds, you purchase them at a set yield-to-maturity, which is the expected return you would earn if you were able to reinvest each coupon payment at the same yield rate. Unfortunately, there is no such thing as DRIPs on bonds. As such, there is no way to guarantee you will actually realise the yield-to-maturity since you don't know at what interest rate you will be able to reinvest the coupon payments. Inflation risk has to do with the risk that inflation rises and decreases the purchasing power of your investment. When inflation increases, bond yields tend to increase (driving down bond prices) because new investors demand compensation the the expected decrease in the real return that the bond will yield. If inflation is increasing prices at 2% per year, then a 6% nominal yield on a bond is really only yielding a real return of about 4%. While stocks prices have a tendency to keep pace with inflation because corporations tend to increase dividends to keep pace, bond returns get clobbered by inflation since in most cases the coupon payments and the repayment at maturity are fixed. Default risk is simply the risk that the issuer is unable to pay the coupon interest payments or repay the face value at maturity and goes bankrupt. In bankruptcy though, bondholders tend to fare better than shareholders because bondholders have a higher priority claim on a company's assets than the shareholders. Senior issues backed by specific collateral have the lowest default risk, while subordinated unsecured issues have the highest risk (which is still lower than the risk to the common shareholders). Long term bonds have more default risk than short term bonds. Related to default risk is credit rating risk. Credit rating agencies usually provide an issue-specific rating on a bond when it is issued, and then continue watching the company to ensure that its ability to make coupon payments and repay at maturity isn't changing. If a credit rating agency things a company's ability to service its debts is deteriorating, it will put it on watch for a credit rating downgrade. If the credit rating does get downgraded, then the bond yields demanded in the market for that issue will rise. Of course, a downgrade doesn't affect the investor's ability to realise the yield-to-maturity so long as the issuer can continue to make coupon payments and repay at maturity. It does affect the investor's ability to sell the bond and break even though. Take the Brookfield issue as an example. Suppose you bought part of this issue and soon afterwards S&P cut the credit rating on the issue from A- to BBB. This would cause the yield demanded in the market to increase above the 9.00% at which you bought the issue. As long as Brookfield can continue to service its debts, your ability to realise that 9% return is not in much jeopardy (keeping in mind what I already said about reinvestment risk), but if you try to sell your bonds, you will probably get less than what you paid for them. As for what you said about the terms of the new issue being more attractive than those currently on the market. This is an illusion. The fact is, that a spread is already built in to the price. The institutions in the bond underwriting syndicate might have only paid Brookfield $99.00 for $100 of face value, and then sold most of the issue to the selling group members of the syndicate at $99.50 for $100 of face value. The selling group members then go and sell to investors at say, $99.75 for $100 of face value. There is no getting around this; an investors can't buy the issue at $99.00, which was the price that the syndicate members paid. Individual investors probably get the worst deal, as large volume purchasers, such as mutual funds, may be able to negotiate a better price than $99.75 with the selling group. Really, I wouldn't read too much into the width of the bid/offer spread on the market. If I was going to hold a bond to maturity, I wouldn't be too concerned with the bids of bond dealers. Bonds are not meant for frequent trading (arguably, neither are most stocks). If you buy and sell bonds a lot, the bid/offer spread can be a profit killer; so don't do it. At the same time though, bonds aren't just about interest income. If you expect interest rates or credit spreads (roughly the spread between the bond's yield and the yield of a risk-free government bond with close to the same maturity date) to fall, then you might be able to sell prior to maturity and net a healthy capital gain.