What is a Bond and How Do They Work? - MagnifyMoney

What Is A Bond? Fixed Income 101

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Stocks and bonds are like the salt and pepper of the investment world — they’re both key ingredients of a well-seasoned portfolio. And depending on your investment goals, your portfolio might need more of one or the other.

But what is a bond, and why would your portfolio need more or less of what they offer?

Bonds are loans that investors make to companies, agencies and governments. While stocks tend to get the most hype for their wild price movements, bonds can offer steady income and reasonable rates of return — and with less risk than stocks.

What is a bond?

Bonds are securities that are, in the simplest terms, loans between an issuer (the borrower) and you (the lender).

When you buy a bond, you become the bank and lend money to a company or government entity. In exchange for your loan, those entities agree to pay you interest (your coupon payment) for the term of the loan until the loan is paid in full — which could be right on time or early, depending on the bond variety (more on bond varieties in a minute).

Your interest payments can be made at various intervals, such as quarterly, semiannually or annually. A bond’s prospectus, also known as an offering document, spells out the frequency of and dates for your coupon payments.

Who issues bonds and why?

A wide range of entities issue bonds for various reasons. If a city needs a stadium built? It issue bonds. And if a public company needs cash to fund a new expansion? It issue bonds, too.

These are the most common types of bonds — named for the entity issuing them — and what the money raised typically funds:

  • Corporate bonds. Both public and private companies issue bonds to raise money at a lower cost than borrowing from a bank. Companies generally use the money raised by bonds to fund various operational expenses.
  • Municipal bonds. Also known as “munis,” state and local governments issue bonds to fund improvements that benefit the public, like schools and highways.
  • Treasury bonds. The federal government issues various types of bonds through the U.S. Treasury. The proceeds often help cover budget shortfalls and support U.S. monetary policy.
  • Agency bonds. Various government agencies (like the Government National Mortgage Association (Ginnie Mae)) and government-sponsored entities (GSEs) (like the Federal Agricultural Mortgage Corporation (FAMC)) also issue bonds to fund various agency programs.

How do bonds work?

Most bonds work like a typical loan — there’s an amount borrowed at a set interest rate for a fixed term. Here’s a step-by-step guide to how bonds work:

  1. How much? The bond issuer decides what the size of the bond issue will be — that is, how much money they need to borrow. For instance, a company might decide to issue $12 million in bonds.
  2. How long? The issuer then decides how long they want that $12 million loan to last. This period is the bond’s term, which spans from the issue date to the maturity date.
  3. At what rate? Finally, depending on the issuer’s credit rating and prevailing interest rates, the issuer will set the bond’s coupon — the fixed interest rate you’ll be paid by the issuer throughout the bond’s term.


Bonds in action

Let’s say you buy a new $1,000 bond from Big Search Engine Company (BSE Co.) with a 10-year term and 5% annual coupon. That means that each year, you’ll receive a $50 interest payment ($1,000 x 5%). Then, at the end of 10 years (your bond’s maturity date), BSE Co. will give you your original investment of $1,000 back … unless they go bankrupt.

(Although, big search engine companies tend to have staying power, so we wouldn’t be too worried about this company’s future.)

What characteristics do all bonds share?

Let’s expand on the three-step process outlined above by defining some important bond terms you need to know. These terms relate to every bond issued in the marketplace:

  • Issue price. Also called a bond’s face value or par value, the issue price is the amount you agree to loan the bond issuer.
  • Maturity date. This is the date the issuer will pay you back your principal investment. Bonds have varying maturities, including short, medium and long term.
  • Coupon rate. The fixed interest rate you’re promised when you buy a new issue bond? That’s the coupon rate. This rate remains unchanged over the bond’s life, unless you have a variable-rate bond.
  • Bond rating. Bond ratings correlate to a bond’s risk of default by the issuer. Three separate agencies set bond ratings: Fitch, Moody’s and Standard & Poor’s. Bond ratings range from investment-grade (the highest rating and lowest default risk) to high-yield or junk bonds (the lowest rating and highest default risk).
  • Coupon dates. These are the dates you’ll receive your coupon payments. They’ll be spelled out in your prospectus.
  • Yield. There are two types of bond yields: coupon yield and current yield. Coupon yield is the same as the coupon rate — the interest promised for the bond’s term, expressed as a percentage. On the other hand, the current yield divides the coupon yield by a bond’s current market price. As a result, the current yield could be higher or lower than the bond’s original coupon yield at issue.
  • Duration risk. When interest rates fluctuate, bond values fluctuate, too. Duration risk measures the likelihood that market rates will impact a bond’s value.

Do bonds come in different varieties?

Absolutely. Having different bond varieties to choose from lets you customize the type of bond you buy according to your financial goals and risk tolerance. These are some of the most popular bond varieties you’ll encounter on the bond market:

Callable bonds

Also referred to as redeemable bonds, the issuer may call upon these bonds before the maturity date. A bond’s prospectus will clearly state whether it’s callable and at what points the issuer can pay off (call) their bonds.

Puttable bonds

The opposite of callable bonds, puttable bonds (also known as put bonds) allow you to redeem your bond early with the issuer. Your prospectus will clearly state the early redemption date(s).

Convertible bonds

Convertible bonds allow you to convert the money you invested in a corporate bond into shares of the issuing company’s stock at a predetermined price.

Variable-rate bonds

Also known as floating rate bonds, variable rate bonds adjust their interest rates periodically based on the interest rate index they’re linked to — the LIBOR index is one example.

Zero-coupon bonds

Unlike most bonds, these bonds don’t offer regular coupon payments throughout their terms. Instead, you purchase zero-coupon bonds at a discounted rate (below face value). At maturity, you then redeem your bond for full face value. The difference between your discounted price and the bond’s face value will be your profit.

Advantages of bonds

Bonds come with several advantages that can make them a sought-after, low-risk investment, including:

  • Diversification. Having bonds in your portfolio can help buffer against price volatility your equity investments, like stocks. For example, bond prices tend to rise when the economy sends stock prices lower.
  • Safety. Bonds — and higher-grade bonds in particular — generally carry less risk, especially compared to stocks.
  • Income planning. When you buy bonds that issue regular coupon payments, you’ll have a predictable stream of income — a bonus for those in retirement.
  • Profit potential. If you own a bond with a yield higher than new bonds can offer, you can potentially sell your bond on the secondary market at a premium. 

Disadvantages of bonds

While bonds are widely considered less risky investments than stocks, they also have downsides. These might include:

  • Credit risk. If a bond issuer defaults on their debt obligation or goes out of business, your coupon payments could stall. You could also lose your principal investment.
  • Inflation risk. Interest rates typically rise when inflation goes up. Thus, the longer a bond’s term, the more susceptible it is to inflation risk. When bond yields go up during inflationary times, bonds with lower yields lose value.
  • Interest-rate risk. If you want to sell your bond before its maturity date, you may have to sell for less than par value if interest rates are higher today than when you purchased the bond. For example, if you want to sell a bond with a par value of $1,000 and a 3% coupon when new-issue bonds have a par value of $1,000 with a 5% coupon, you’ll likely have to sell your bond for less than $1,000 to make your bond’s lower coupon rate attractive to other investors.
  • Lower potential return. Lower-risk investments like bonds typically come with lower rates of return.

Are bonds a good investment?

What’s good for one person might not be good for another. The more important question is, “Are bonds a good investment for you?” The answer has to do with what you need as an investor and where you are in your investment journey.

Bonds could play more of a role in your portfolio if:

  • You’re nearing retirement and are less concerned with accumulating wealth and more interested in preserving the wealth you’ve gained.
  • You want predictable income and don’t mind trading higher rates of return for lower risk.
  • You have an aggressive portfolio composed primarily of stocks and want to lower your portfolio’s overall risk.

Bonds might play less of a role in your investment portfolio if:

  • You’re early in your investment journey, and your goal is to accumulate wealth for the future.
  • You’re investing in a low interest rate environment, which usually translates to low coupon rates and yields.
  • You have a more complex tax situation, limiting the types of bonds you can buy to those with no state or federal income tax liability (typically municipal bonds).

There’s rarely a portfolio that wouldn’t benefit from some sort of exposure to fixed income like bonds. For you, it’s all about finding the mix of equities (like stocks) and fixed income (like bonds) that make the most sense for your investment goals, time horizon and risk tolerance.

If you’re curious about what your ideal portfolio mix of stocks and bonds might look like, check out our in-depth look at asset allocations by age. You can also find a financial advisor who can review your finances and help you build an asset mix designed to grow with your goals over time.

The bottom line

Now you know the basics about what bonds are and how they work — and if you decide to tell a friend about bonds, you won’t give an answer that has to be taken with a grain of salt. As for the question of whether bonds make good investments, it all depends on your circumstances. In general, however, bonds (like pepper) shouldn’t be your main course, but adding some in the mix is a great way to season a well-diversified portfolio.

If you’re curious to keep learning about bonds, be sure to check out our guide to buying bonds and explore different bond trading strategies that might benefit your portfolio.

Frequently asked questions

What are I bonds?

Series I bonds are savings bonds issued by the U.S. Treasury with interest rates tethered to current inflation rates. An I bond’s interest rate adjusts every six months to reflect the current inflation rate.

Can you sell bonds on the secondary market?

If you want to sell your bond before its maturity date, you can sell bonds on the secondary market. Secondary markets can be organized exchanges, like those offered by online brokerages. Over-the-counter markets are another example of a secondary market, where a broker-dealer network matches buy and sell orders.

How do you buy bonds?

You can buy bonds in three ways: individual bonds, bond ETFs and bond mutual funds. New issue bonds can be purchased through a broker or on secondary exchanges after issue. Bond ETFs and mutual funds can be purchased through a financial advisor or online brokerage.