What is a bond?
Bonds can add stability and income to portfolios.
- A bond is a loan to a government, agency, or company that is repaid with interest.
- Bonds complement stocks and other more aggressive investments in a portfolio.
The IOUs of the financial world, bonds represent a government's, agency's, or company's promise to repay what it borrows—plus interest. Though they typically don't make the attention-grabbing moves that stocks do, bonds still can play a vital part of your financial plan, providing a sense of stability and consistent income.
Most bonds pay regular interest until the bond matures.
What is a bond?
A bond is essentially a loan an investor makes to a borrower. As with loans that you take out yourself, bond investors expect to receive full repayment of what was borrowed and consistent interest payments.
Many investors value bonds for the regular income they offer through these interest payments, as well as the comparative safety they provide compared to stocks. While stock values fluctuate day to day, highly rated bonds essentially assure investors that they will see repayment of the amount they invested plus modest interest. Going back more than 90 years, investment-grade bonds as a category have not had a single 5- or 10-year period in which they offered negative returns.*
This makes them valuable ways for investors to help diversify and minimize the risk in their investment portfolios. For more on the role bonds can play in a portfolio, see our guide to diversification.
How do bonds work?
There are a few key terms to keep in mind when it comes to understanding how bonds work:
This is the government, government-sponsored enterprise, or company that seeks to fund its activities with a loan. It issues bonds as part of its promise to repay its debts.
Generally, this is when you will receive repayment of what you loaned an issuer (assuming the bond doesn't have any call or redemption features). If you want or need to sell a bond before its maturity date, you may be able to sell it to someone else, though there is no guarantee you will get what you paid.
Face value (a.k.a. par value)
This is the value the bond holder will receive at maturity unless the issuer fails to repay the loan, a practice called defaulting. Investors usually pay par when they buy a bond from the issuer, unless it's a zero-coupon bond, which we cover more below. If investors buy the bond from someone else (meaning they buy it on a secondary market), they may pay more or less than face value. Check out our guide on bond prices, rates, and yields for more on how bond rates change over time.
This is the annual percentage of interest the issuer pays someone who owns a bond. The term "coupon" originates from when bond certificates were issued on paper and had actual coupons that investors would detach and bring to the bank to collect the interest. Bonds may have fixed, unchangeable rates or floating coupon rates, meaning they adjust over time based on a predetermined formula. Most bonds make interest payments semiannually based on the principal (the amount they originally borrowed), although some bonds offer monthly and quarterly payments.
Bond ratings indicate the financial health of the issuer and how likely they are to repay their debts. Ratings agencies such as Standard & Poor's, Moody's, and Fitch assign a rating that indicates their opinion of whether the bond is "investment grade" or not. Higher-rated bonds are considered safer and can be attractive even with lower interest rates, whereas lower-rated bonds pay higher interest rates to compensate investors for taking on more perceived risk. An issuer's bond or credit rating can change over time.
Callable bonds are bonds that the issuer can repay, or call back, early. Issuers may recall bonds if interest rates fall low enough that they can issue comparable new bonds at substantially lower rates and save money overall. The attraction of callable bonds for investors is that they typically offer higher rates than noncallable bonds, though there is no guarantee that they would be able to find a similar rate on a new bond—or even one equal to the current market rate when they buy their callable bond—if their bond is recalled. Callable bonds often have guidelines governing how soon they can be recalled and if the issuer must pay a premium on the principal if they do.
Also known as "strips," these are bonds that do not make periodic interest payments. In other words, there's no coupon. Instead, you buy the bond at a discount on its face value and receive one payment of the full face value at maturity. For example, you might pay $16,000 now on a 10-year zero-coupon bond with a face value of $20,000. In a decade, when the bond is mature, you’ll receive a payment of $20,000. Perhaps the best-known example of a zero-coupon bond is a US savings bond. Note: Investors interested in bonds may also consider brokered certificates of deposit (CDs), which work similarly to bonds: Not only do they return their full par value at maturity but they are also FDIC-insured, meaning they guarantee the return of your principal up to the FDIC limits. For more on CDs, see What is a CD?
Types of bonds
The US Treasury issues bonds to pay for government activities and to service the national debt. Treasuries are considered to be extremely low risk if held to maturity, since they are backed by "the full faith and credit" of the US government. Because of their safety, they tend to offer lower yields than other bonds. Income from Treasury bonds is exempt from state and local taxes.
Government-sponsored enterprises (GSEs), like Fannie Mae, Freddie Mac, and the Tennessee Valley Authority, issue bonds to support their mandates. That typically involves ensuring certain segments of the population—like farmers, students, and homeowners—can borrow at affordable rates.
Yields are higher than government bonds, representing their higher level of risk, though are still considered to be on the lower end of the risk spectrum. Some agency bonds, like Fannie Mae and Freddie Mac, are taxable. Others are exempt from state and local taxes.
Municipal bodies, like states, cities, counties, and towns, issue bonds to pay for public projects (think: roads, sewers) and to finance other activities. The majority of these bonds, commonly called munis, are exempt from federal income taxes and, in most cases, also exempt from state and local taxes if the investor is a resident of the state that issues them. As a result, the yields tend to be lower but still may provide more after-tax income for investors in higher tax brackets.
Companies issue bonds to expand, modernize, cover expenses, and finance other activities. The yield is generally higher than government and municipal bonds, though they do carry more risk. Bond rating agencies help you assess that risk by grading the bonds based on the issuing company's creditworthiness, or how likely it is to repay its loans. Income from corporate bonds is fully taxable.
Mortgage-backed securities (MBS)
Banks and other lending institutions pool mortgages and "securitize" them so investors can buy bonds that are backed by income from people repaying their mortgages. This raises money so the lenders can offer more mortgages. Examples of MBS issuers include Ginnie Mae, Fannie Mae, and Freddie Mac. Mortgage-backed bonds have a yield that typically exceeds high-grade corporate bonds.
The major risk of these bonds is that if borrowers repay their mortgages in a "refinancing boom," it could have an impact on the investment's average life and potentially its yield. These bonds can also prove risky if many people default on their mortgages. Mortgage-backed bonds are fully taxable.
Some issuers simply aren't as creditworthy as others and must offer what are known as high-yield bonds. High-yield issuers can be local and foreign governments, but they're most commonly companies that are considered by bond ratings agencies to be at greater risk of not paying interest and/or returning principal at maturity. As a result, the issuer will pay a higher rate to entice investors to take on the added risk. These bonds are frequently rated below investment grade by credit agencies and are considered speculative; you may also hear them referred to as "junk bonds."
How to buy bonds
Most investors get exposure to different types of bonds through bond funds. These may be through mutual funds or exchange-traded funds (ETFs). In either case, they are researched and curated by professionals or aim to recreate the performance of indexes tracking leading bonds. Bond funds allow you to minimize your risk by investing in potentially hundreds of bonds at once and can readily be bought through regular investment accounts, like taxable brokerage accounts, individual retirement accounts (IRAs), and 401(k)s. In addition, you can easily sell shares regardless of bond maturity dates.
Some investors may choose to research and invest in new-issue and secondary market individual bonds through their brokerages. Investing in bonds this way allows investors to hold bonds to their maturity dates and avoid losses caused by price volatility. Doing so, however, requires a greater knowledge of the bond industry, credit ratings, and risk, and single bonds may be more difficult to sell quickly before their maturity date.
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