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When you purchase a bond, you’re effectively lending money to the company or government issuing the bond. In return, the issuer pays interest on a regular basis and then returns the principal on the loan when the bond matures. This can make bonds attractive for people looking for a relatively stable investment.
Different factors can impact the amount of interest you earn from the asset, including the creditworthiness of the bond issuer and the bond’s maturity date. The following guide provides more detailed information on what bonds are and how they work.
Table of content
- How do bonds work?
- Types of bonds
- Why buy bonds?
- Who issues bonds?
- How to buy bonds
- Holding bonds vs. trading bonds
- Advantages and disadvantages of bonds
- Characteristics of bonds
- Bonds FAQs
How do bonds work?
You can think of bonds as an IOU between you and a government, country or other bond issuer. When you buy a bond, you’re essentially acting as a lender. You provide the issuing party with a principal payment of capital and they promise to pay that capital back over a set period of time with interest payments.
For example, the U.S. government offers U.S. treasury bonds. Let’s say you buy a10-year bond for $10,000 that pays 3% interest. You would begin receiving 3% of $10,000, or $300, each year for 10 years. At the end of that 10-year repayment period, the life of the bond would be complete and you would get your initial $10,000 investment back.
“Unlike a stock where you’re not sure of future cash flows of the company, with bonds you know exactly what they’re going to be,” says advisor Rick Ferri of Portfolio Solutions. “The only risk is that the issuer ends up defaulting and doesn’t pay the debt.” The flip side of bonds’ low risk is that they have less potential than stocks for high returns.
Many bonds today are callable, which means that the bond issuer can call a bond back from an investor before it matures. This allows the issuer to pay off the bond when interest rates are low. Because they can be called back at any time, callable bonds are riskier for investors. To make up for this risk, they usually come with a higher annual return rate.
Types of bonds
Bonds are often associated with the federal government, but they can be issued by other organizations as well. Here are the different types of bonds you may be able to choose from as you put together your bond portfolio.
U.S. Treasury bonds
U.S. treasury government bonds are backed by the full faith and credit of the United States. They’re viewed as the most secure type of bond you can purchase because the risk of default is extremely low.
However, these bonds also typically offer relatively low interest rates. This means your money may be safe, but you might not earn as much as you could with other types of bonds.
Corporate bonds are issued by companies that want to raise funds. These bonds are often graded by rating agencies, such as Standard & Poor’s or Moody’s. Bond ratings provide an investment grade so you have an impartial sense of how secure the offering is.
Corporate bond funds typically offer higher interest rates because they’re viewed as riskier. The general reasoning behind this is that corporations are more likely to go out of business than governments are to collapse.
Corporate bonds can be one way to get risk-adjusted exposure to corporations you want to invest in. If you're interested in purchasing bonds from multiple corporations, then a bond exchange-traded fund (ETF) could make sense.
ETFs bundle together multiple, often related, assets so you get broader market exposure through a single investment. There are thematic ETFs that focus on one investment trend, such as clean energy funds and mutual fund ETFs that are built for people retiring in certain years.
There are also bond ETFs, which give you exposure to an array of corporate bonds to spread out your risk and potentially benefit from more returns. Bond ETFs may be one of the best ETFs for your goals if you're looking for a relatively low-risk way to earn more interest on your cash.
Municipal bonds are issued by non-federal government entities, including states, counties and cities. They enable smaller government bodies to raise funds without increasing mandatory local taxes.
Your credit risk from municipal bonds will depend on the finances of the city, state or county that you’re investing in. Municipal bonds are often viewed as higher risk than federal government bonds.
Agency bonds are issued by government-sponsored enterprises (GSEs). These are organizations that were created through Acts of Congress to promote the movement of capital to specific market sectors.
For example, the Federal National Mortgage Association (FNMA) is a GSE that was chartered by the government to help ensure a reliable source of funding for private mortgages.
Some of the most common issuers of agency bonds are:
- Federal National Mortgage Association, or Fannie Mae (FNMA)
- Federal Home Loan Mortgage Corporation, or Freddie Mac (FHLMC)
- Federal Home Loan Bank (FHLB)
Agency bonds typically pay slightly higher interest rates than U.S. Treasury bonds. This is because they aren't backed by the full faith and credit of the United States.
However, when FNMA nearly collapsed in the housing crisis of 2008, the federal government bailed them out. This explains why, though agency bonds aren't technically backed by the full credit of the U.S. government, they’re typically viewed as more secure than corporate bonds.
Why buy bonds?
You may wish to become a bondholder as part of a broader investment strategy. Bonds, especially those sold by the federal government, provide a low-risk way to put your money to work. You can earn more interest on your cash than you would from storing it in even a high-yield savings account.
Bonds can also be a great form of diversification, allowing you to spread your capital across multiple assets and mitigate the risk of substantial losses resulting from a single poor investment choice. Most bonds lack the same level of volatility as the stock market, so you can keep a percentage of your total portfolio safe from the fluctuations of equities by purchasing them.
The downside of bonds is that they may not keep up with interest rate changes — this can make them worth less over time. For example, if you purchase a 10-year bond and the Treasury later decides to increase interest rates, the bond may no longer pay you a high enough interest rate to beat inflation. Analysts call this inflation risk or interest rate risk.
Bond prices and interest rates
As you continue thinking about bonds and whether you should add them to your investment portfolio, it’s worth reviewing their relationship to interest rates. As a general rule of thumb, bond prices tend to go down when interest rates go up.
This means that if you own a bond and the federal government increases interest rates while it’s active, the resale value of that bond will likely go down. But the opposite is also true. If you purchase a bond when interest rates are high and they begin going back down, your bond could go up in value.
The takeaway is that understanding where interest rates are likeliest to go in the future could help you determine whether a bond investment is the right move at this moment. You can read what analysts have to say to learn more.
Who issues bonds?
There are very few limitations on who can issue bonds, but they’re most commonly issued by organizations that are likely to be financially stable when the bond expires. This is why you typically only see government organizations and large, successful companies issue bonds.
How to buy bonds
You can purchase bonds in a few different ways. One option is to buy them directly through the federal government by accessing its TreasuryDirect portal online. This is where you go to find new bonds issued by the Treasury Department.
You can also buy bonds through your brokerage. For example, Fidelity, Robinhood and most other brokers make various bond offerings available to their customers.
Holding bonds vs. trading bonds
Many people who purchase bonds do so intending to hold them until maturation. This is the practice of holding bonds.
But there's another way to invest in this asset class. It involves buying and selling bonds more frequently on secondary trading markets, to potentially profit from bond price fluctuation over time. This is called trading bonds.
There are different reasons you may want to both hold bonds long-term or trade them in the short-term. For example, holding a bond will ensure you get your full capital investment back when the term expires. It can also help you fulfill your long-term portfolio diversification strategy.
Trading bonds can be beneficial if you want to place bets on short-term fluctuations in interest rates. If you believe that interest rates will decrease in the near future, buying bonds before the decrease and selling them afterward can result in a profitable outcome. If you decide to trade bonds, keep in mind any trading fees when considering your potential costs versus returns.
Advantages and disadvantages of bonds
- Bonds are relatively safe
- Bonds are a form of fixed income
- Low-interest rates
- Some risk
Characteristics of bonds
As you start thinking more seriously about purchasing bonds, it’s worth familiarizing yourself with a few key terms.
The coupon rate refers to the interest rate on the face value of a bond. A 10% coupon rate means you’ll be paid 10% x $1,000 face value; or $100 per year.
The coupon date is when the issuer will make payments — often semiannually.
The yield of the bond is the amount that you should expect to receive from the bond’s interest, or coupon, payments. For example, 3% on a $10,000 bond would equate to a yield of $300 annually. This differs from yield-to-maturity, which looks at the total amount you can expect to earn over the lifespan of the bond.
The face value, or par value, of a bond is the dollar amount the issuer will pay when the bond matures. It can fluctuate as interest rates move and is calculated by considering the amount of future cash flows the bond is expected to generate.
Price is straightforward when it comes to bonds. It refers to how much a bond costs if you want to buy it.