What Is a Bond?

A bond is a security that typically pays investors a fixed interest rate. Governments or companies can issue bonds to borrow money for operations or expansion. These securities typically pay regular interest until they reach maturity.

A bond is a loan with a promise to repay the borrowed money and interest. The issuer might compensate investors by selling the bond at a discount and paying the face value at maturity, such as with Treasury bills.

Bonds can help balance risk and reward within an investment portfolio. These securities offer safer, more predictable investments than stocks.

How Bonds Work

A bond works similarly to a loan:

• The bond owner acts as the lender.

• The issuer acts as the borrower.

• The borrower agrees to pay the lender back with interest, or sells the bond below face value and pays the lender the face value at maturity.

Bonds typically offer a fixed interest rate paid twice annually and return the principal amount on the maturity date. For instance, say an investor purchases a four-year, $2,000 bond with a 5% fixed interest rate paid semiannually. The investor would earn $50 in interest every six months. When the bond matures, the investor will have earned $200 in interest and will receive their $2,000 back.

 Bond Terms  

Understanding the following bond terms helps you determine whether to purchase a bond when it is issued and hold it to maturity, or buy and sell one on the secondary market:

• Coupon: The interest rate the bond pays.    

• Yield: A measure of interest that accounts for the bond's fluctuating changes in value. The simplest option to measure yield is to divide the bond's coupon rate by its current price, known as the current yield.

• Face value: The amount the bond is worth when it's issued, also known as par value.  

• Price: The current cost to purchase the bond on the secondary market.  

Types of Bonds

Whereas some companies issue bonds, most bonds are issued by governments or government agencies. The main types of bonds are U.S. Treasuries, government agency bonds, municipal bonds, and corporate bonds.

U.S. Treasuries

U.S. Treasuries are considered the safest bonds:

• Treasuries are extremely liquid.

• The interest is generally exempt from state and local taxes.  

• Because the bonds are very safe, the yields are generally the lowest available.

• Investors pay federal income tax on the interest.

• The payments might not keep pace with inflation.

U.S. Treasuries offer variable maturity terms and features:

• Treasury bills have maturities of one year or less and do not pay interest. They are issued at a discount, meaning investors pay less than face value when purchasing them, and pay the face value when the bond reaches maturity.

• Treasury notes have maturities between two years and 10 years.

• Treasury bonds have maturities of more than 10 years, typically 30 years.

• Treasury inflation-protected securities (TIPS) have a return that fluctuates with inflation.

• Separate trading of registered interest and principal of securities (STRIPS) is a Treasury that has had its coupon payments stripped away, meaning the coupon and face value portions are traded separately. STRIPS are sold below face value and pay investors the face value at maturity.

• Treasury floating rate notes have a coupon that fluctuates based on the rate offered by recently auctioned Treasury bills.

Government Agency Bonds

Some U.S. government agencies, such as housing-related agencies like the Government National Mortgage Association (GNMA), can issue bonds:

• Because the U.S. government backs some agency bonds, they are almost as safe as Treasuries.

• The bonds are typically high-quality and very liquid.

• Because mortgages can be refinanced, bonds backed by agencies such as GNMA are susceptible to interest rate changes.

• Most agency bonds are taxable at the federal and state levels.

• The yields might not keep pace with inflation.

Municipal Bonds

A state or other municipality issues a municipal bond:

• A municipal bond is generally safe because the issuer can raise money through taxes.

• The interest is typically free from federal income tax and state taxes in the state in which it is issued.

• Yields generally are lower than those of federally taxable bonds because of the favorable tax treatment.

• The issuer still can default on the loan.

Corporate Bonds

A company issues a corporate bond:

• Because corporate bonds are less safe than government bonds, their yields are typically higher.

• The company’s credit risk can be low or high.

• Interest is taxable at the federal and state levels.

• High-yield bonds, also called junk bonds, are issued by companies with low credit ratings.

• Because junk bonds come with a greater risk of default, investors expect higher yields.

Benefits of Purchasing Bonds

Purchasing bonds provides the following benefits:

• Diversification: Spreading risk across different asset types increases portfolio stability.

• Predictable payments: Most bonds offer regular interest payments, which help stabilize a portfolio and provide regular income.

• Less volatility: Bonds tend to be much less volatile than stocks and have lower risks, acting as a buffer against the effects of a volatile stock market.

• Potential tax advantages: Municipal bonds are typically tax-free at the federal level, while U.S. Treasuries are typically exempt from state and local taxes.

• Returns that can outpace inflation: Bonds help hedge against the effects of inflation.

Bond Yields and Interest Rates

Bond prices and interest rates have an inverse relationship, meaning they tend to move in the opposite direction:

• When interest rates rise, bond prices tend to fall.

• Investors can purchase new bonds with yields that reflect the new, higher interest rate.

• Older bonds become less attractive, causing their prices to decline.

• If interest rates decline, the yield on new bonds will be lower.

• Older bonds and their comparatively higher yields are more attractive to investors.

Holding Bonds Versus Trading Bonds

If you purchase a bond, you can collect interest payments while waiting for the bond to reach maturity, or buy and sell bonds on the secondary market. The susceptibility to changes in value is an important consideration when choosing your bond:

• After a bond is issued, the worth fluctuates.

• If you hold the bond to maturity, the fluctuations will not matter, since your interest payments and face value will not change.

• If you buy and sell bonds, you must remember that the price you pay or receive is no longer the face value of the bond.

Risks of Owning Bonds

Consider the following risks of owning bonds before you decide to purchase one:

• Liquidity risk: If you own bonds that don't trade frequently, you might experience difficulty accessing your money.

• Default risk: If the issuer defaults, it might fail to make scheduled interest payments or repay your principal.

• Call risk: If you own callable bonds, the issuer can redeem the bond before maturity, and you could miss out on future interest payments.

• Interest rate risk: If interest rates rise, the prices of the bonds you own could decline.

• Inflation risk: If inflation is high, it could outpace the fixed interest rate paid on your bond, reducing your purchasing power.

• Reinvestment risk: If you plan to reinvest any interest earned or principal returned, you might receive a lower yield on the new investment if rates have declined.

Bond Maturity and Duration

A bond's maturity is the length of time until you receive the face value. Changes in overall interest rates have a greater effect on bonds with a longer maturity. For instance, if current interest rates are 2% lower than your existing mortgage rate and you have 3 years left on the loan, it will matter much less than it would for someone who has 25 years of payments remaining on theirs.

Bonds with longer maturities are more sensitive to changes in interest rates, increasing their level of risk. As a result, these bonds tend to offer higher yields, making them more attractive to potential buyers.

The relationship between maturity and yields is called the yield curve. In a normal yield curve, shorter maturities equal lower yields.

Bond duration, like maturity, is measured in years. The duration is a complex calculation that involves the bond's present value, yield, coupon, and other features. The duration is the best way to assess a bond's sensitivity to interest rate changes.

How Bonds Are Rated

Bonds are rated by independent rating agencies, such as Standard & Poor's, Moody's, and Fitch Ratings, that analyze a bond issuer's creditworthiness and assign a rating. These agencies consider the issuer's financial situation, credit history, and other factors to determine if the issuer is likely to meet its financial obligations, including repaying its bondholders.

Credit ratings are assigned on a scale ranging from AAA, the best possible rating, to C or D, the lowest possible rating. When a bond issuer receives a strong credit rating, BBB− or higher for S&P and Fitch, or Baa3 or higher for Moody's, its bonds are referred to as investment grade, indicating that a default is unlikely. Since bonds issued by higher-credit-rated issuers carry less risk, they tend to pay lower yields than bonds rated below investment grade.

*This information is for educational purposes only.

Do you own or plan to purchase bonds? Let me know in the comments!