What is a bond?
It’s a loan that investors provide to government or corporate issuers
Bonds may seem like a boring investment, but they have been a staple in balanced investment portfolios for hundreds of years. Bonds are a core part of corporate and government operations in the U.S. and around the globe, helping companies and other entities raise money outside of commercial bank loans.
In essence, bonds are loans from investors to corporate or government borrowers, used to raise capital or pay for operating expenses. Bonds typically pay out regular interest payments to investors and are considered a fixed-income investment.
Key insights
- Bonds are issued by businesses and government entities to raise money for projects, operating expenses and growth.
- Bonds pay out regular income in the form of coupon payments, typically every six months.
- Bonds can lose value in rising interest rate environments, depending on the type of bond and maturity date.
How do bonds work?
“A bond is an IOU from a corporation, government entity or municipality,” said Frank Murillo, managing director at Snowden Lane Partners in Miami.
“In exchange for loaning them this money (the IOU), you are paid a rate of interest for the term of the bond. The principal risk with bonds is if the entity you loaned money to defaults or becomes insolvent — at which point you are out the future interest and your principal. Not all bonds are created equal and, like a report card, many of them are graded on a scale (anything rated ‘A’ is typically a good sign).”
Who issues bonds?
Bonds are issued by corporate and government entities to raise capital. Bonds may be issued when other funding is not available, or to access more capital than would otherwise be available.
Here are the main entities that issue bonds:
- Corporations: Businesses that are raising money for operating costs or business growth may issue bonds to help pay for these obligations.
- U.S. Treasury: The U.S. Treasury issues several types of bonds that vary in maturity and interest rates. Some offer a discount upfront, while others pay out regular interest payments.
- Government-affiliated agencies: Some government agencies and affiliated businesses issue bonds, such as the Federal Housing Administration (FHA).
- Government municipalities: State and local governments issue bonds to raise capital for local projects, such as road improvements or a new stadium.
» MORE: What is a good investment?
How to buy bonds
You can buy individual bonds or preselect bonds bundled into a mutual fund or exchange-traded fund (ETF) through most major investment firms, as well as directly from the U.S. government.
Here are a few places where you can buy bonds:
- U.S. Treasury: You can purchase government-issued bonds directly from the U.S. Treasury by going to TreasuryDirect.gov. You can purchase Treasury bills, notes or bonds.
- Broker: Most major investment brokers sell bonds and bond funds for minimal trading fees. Companies like Fidelity or Charles Schwab have a large selection of both individual bonds and bond funds.
- Online brokers and apps: Most investing apps and online brokers offer access to bond funds or bond ETFs. This allows you to own hundreds (or even thousands) of individual bonds within a single investment. For bond ETFs, you can trade these actively in the open market.
» MORE: How to open a brokerage account: step-by-step instructions
Bond rates
Bonds are loans with fixed or variable interest rates. The interest paid on a bond is known as the “coupon rate.” These rates are set by the bond issuer and are affected by the current interest rate environment, bond maturity, risk profile and the issuer themselves.
Coupon payments are paid on a regular basis, typically semi-annually or quarterly. These payments reflect interest payments to the bondholder. In some cases (such as with U.S. Treasury bills), the bonds are sold at a discount to the face value of the bond at the rate of interest.
Not all bonds are created equal and, like a report card, many of them are graded on a scale (anything rated ‘A’ is typically a good sign).”
Bonds that are deemed “safer” typically have lower rates, while bonds with a higher risk profile may have higher rates. In general, bonds pay higher rates for longer maturities, though in a rising rate environment, this may not be the case.
Bond example
Let’s say you purchase a single U.S. Treasury bond with a 30-year maturity. Treasury bonds offer long maturities of 20 to 30 years in length, but pay out coupon payments in semiannual increments.
If you purchase a U.S. Treasury Bond “at par,” this means you’ll purchase it for a face value of $1,000. You will immediately start collecting interest on the bond, which is paid out every six months. Let’s say the interest rate is 4% annual percentage yield (APY).
At a 4% interest rate, you’ll earn $40 per year (in the form of a 2% coupon payment every six months, or $20). This fixed rate will return $40 per year for the full 30 years. After maturity, you can choose to reinvest your bond principal investment in another bond.
» MORE: Interest rates and how they work
Types of bonds
There are many different types of bonds you can invest in, issued by various entities. Here are the types of bonds available in the public market:
Corporate bonds
Risk: Medium to High
Expected yield: 5% to 10% (or more)
Liquidity: Medium to high
Maturity range: Varies
Taxes: Taxed as ordinary income
Corporate bonds are issued by corporations to raise capital for projects, expansion or other business needs. When investing in individual corporate bonds, there are several ways corporate bonds may be constructed:
- Convertible bonds allow you to convert them to stock in the future. This is more common for corporations that want to lower rates and don’t mind issuing stock to bondholders.
- Callable bonds can be “called” back by the issuer and reissued with a new interest rate. This protects companies when interest rates drop, but can lower the rate for bondholders, resulting in lower returns.
- Puttable bonds allow bondholders to sell back bonds and receive their principal investment back. This gives bondholders more control and allows them to sell back to a company if they believe a bond will fall in price (usually due to rising interest rates).
Corporate bonds are seen as higher risk than government bonds because they are not backed by the U.S. government and the risk of default is higher. Bonds from stable companies typically offer lower rates, while bonds from less stable companies introduce a higher default risk, and thus pay higher rates.
Government bonds (U.S. Treasurys)
Risk: Low
Expected yield: 3% to 5%
Liquidity: Very high
Maturity range: 4 weeks to 30 years
Taxes: Taxed as ordinary income
The U.S. government borrows money in the form of bonds. These bonds come in many different flavors, depending on the maturity date and how they are issued.
Here are the different types of government bonds:
- Treasury bills are short-term bonds with a maturity of one year or less. These are zero-coupon bonds that are purchased at a discount to the face value and earn interest on maturity instead of getting regular coupon payments.
- Treasury notes are medium-term bonds with a maturity between 2 and 10 years. They issue coupon payments semiannually.
- Treasury bonds are long-term bonds with a maturity between 20 and 30 years. They issue coupon payments semiannually.
- U.S. savings bonds come in two different types, including EE Bonds and I Bonds. EE Bonds are guaranteed to double in value in 20 years. I Bond rates fluctuate with inflation.
The U.S. Treasury market is seen as one of the safest and most liquid markets in the world. It is backed by the full faith and credit of the U.S. government and has a very low risk of default. In general, longer-term bonds have higher rates, unless interest rates are actively rising.
Municipal bonds
Risk: Low
Expected yield: 3% to 4%
Liquidity: Varies
Maturity range: 2 to 30 years
Taxes: Tax-free in most cases
Municipal bonds are issued by state and local governments to raise funds for the needs of that municipality. The income from municipal bonds is generally tax-free at the federal and state level.
There are two types of municipal bonds:
- General obligation (GO) bonds are backed by local taxes (such as property taxes) or other general local government funds.
- Revenue bonds are backed by the revenue from a local government project, such as a local stadium or road tolls.
While these bonds generally produce lower yields than U.S. Treasurys, their tax-exempt status can be a boost to investors who want to earn a solid return while offsetting income taxes.
Agency bonds
Risk: Medium
Expected yield: 4% to 6%
Liquidity: Medium
Maturity range: 4 weeks to 30 years
Taxes: Taxed as ordinary income
Agency bonds are issued by government-affiliated agencies (such as the FHA), but don't necessarily have the same protections as U.S. Treasurys. Agency bonds include mortgage-backed securities .
There are two main types of agency bonds:
- Federal government agency bonds are issued by the FHA, the Government National Mortgage Association (GNMA), and the Small Business Administration (SBA). These bonds are backed by the U.S. government, but may be callable, making them slightly less attractive to borrowers.
- Government-sponsored enterprise (GSE) bonds are issued by entities such as Fannie Mae and Freddie Mac, as well as the Federal Home Loan Bank. These bonds vary in maturity and type, but generally pay slightly higher than U.S. Treasurys.
While federal agency bonds are backed by the U.S. government, GSE bonds are not, which increases their default risk. This means GSE bonds may pay slightly higher rates for the increased risk.
What’s the difference between stocks and bonds?
Stocks and bonds are both staples in many investment portfolios, but are very different types of securities. Overall, stocks and bonds don’t have a lot in common other than they are investments that help make up a diversified portfolio.
Stocks
- Are equity investment in a company
- Rise and fall in value based on market supply and demand
- May pay out dividends based on company profit
- Considered a high-risk investment
- Available to trade through national exchanges, such as the New York Stock Exchange
- Sometimes rated and reviewed by stock analysts
Bonds
- Are loans to corporate and government entities
- Prices are typically tied to prevailing interest rates
- Pay out regular coupon payments based on a fixed or variable interest rate
- Tend to be more stable and are considered a low-risk investment
- Usually purchased directly from the government or through an over-the-counter (OTC) trading desk
- Rated by professional ratings organizations
» MORE: How to buy stock
FAQ
What is bond maturity?
Bond maturity refers to the date when a bond will fully repay the principal investment back to borrowers. For example, if you purchase a bond with a five-year maturity for $1,000, you’ll receive interest payments for five years, then get your $1,000 original investment back at the end of the term.
Are bonds risky?
Bonds are generally seen as a low-risk investment, but certain types of bonds have higher risk than others. Corporate bonds or GSE bonds have a higher risk of default as they are not backed by the U.S. government. This means you could lose part, or all, of your principal investment if the bond issuer does not have the capital to repay the bond at maturity. Bonds that have lower ratings (below A) are at a higher risk of default, and should be considered a somewhat risky investment.
What are junk bonds?
Junk bonds are higher-risk bonds that are rated lower than investment grade bonds by Moody’s, Standard & Poors (S&P) and Fitch. This means a Ba rating from Moody’s, or a BB rating from S&P or Fitch, classifies the bond as having a higher risk of default. These are considered by institutional investors as “junk” and not typically chosen for pension funds or other large investment funds.
How are bonds taxed?
Bonds can be taxed in many different ways. In general, most bond coupon payments are taxed as ordinary income, and gains from the sale of a bond are considered capital gains. Some bonds (such as municipal bonds) earn tax-free income from coupon payments.
Bottom line
Bonds are a popular investment for investors looking to earn fixed income with a lower risk than stocks or other high-risk assets. There are many different types of bonds to choose from, each with a different risk profile, yield and tax treatment. Choosing the right bonds to invest in can help diversify your portfolio and provide you with stable income.
But there are risks to investing in bonds that you should consider before putting your money into them. Working with a licensed financial advisor can help you choose the right allocation for bonds and what bonds or bond funds to invest in for your financial goals.
Article sources
- TreasuryDirect, “ Treasury Bonds .” Accessed Sept. 15, 2023.
- TreasuryDirect, “ Treasury Bills .” Accessed Sept. 15, 2023.
- TreasuryDirect, “ Treasury Notes .” Accessed Sept. 15, 2023.
- TreasuryDirect, “ About U.S. Savings Bonds .” Accessed Sept. 15, 2023.
- Fidelity, “ Agency Bonds .” Accessed Sept. 15, 2023.
