- A bond is a loan you make to a company in exchange for income over a fixed period of time.
- Bonds allow individuals to diversify portfolios while mitigating investment risk.
- Unlike stocks, bonds typically offer lower returns and don't come along with ownership rights.
Although stocks tend to garner most of the excitement behind everyday investing, bonds are another major asset class that can offer a valuable way to diversify and possibly reduce risk in your portfolio.
Bonds are loans that investors make to an entity like a corporation or government, typically in exchange for interest payments on a set schedule, with the return of the principal investment at maturity.
Example: Let's say you buy a 10-year bond from company XYZ with a face value of $1,000 and 5% annual interest. In exchange for the loan, company XYZ promises to pay you $50 each year over the decade. After 10 years, the company pays you back the original $1,000 in full, meaning your total $1,000 investment turned into $1,500 over 10 years, after accounting for the $50 interest earned each year.
Bonds represent ownership of debt, as opposed to stocks which represent ownership of the company overall. So while stock values fluctuate based on a company's performance, most bonds are fixed-income securities, meaning the debt is repaid on a predetermined schedule at a set rate.
That often makes bonds safer and less volatile than stocks, though the predictable income often coincides with lower returns.
That said, bond prices and returns can vary significantly based on factors such as credit risk and the interest rate environment, as we'll examine in this guide.
How bonds work
Because bonds represent the ownership of debt, these securities essentially act as promises to repay debt. If all goes well, the company will generally repay the debt plus an agreed-upon interest rate (though certain types of bonds have adjustable rates) over a defined period. However, it's possible that the company goes bankrupt and can not repay debts, although bondholders are prioritized before shareholders in bankruptcies, arguably making bonds a safer investment than stocks usually.
More specifically, some of the main components of how bonds work include the following:
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Issuer and investor
There are two main roles involved with bonds.
The issuer is the entity that borrows money, such as the federal government or a corporation. Sometimes these bonds are issued for specific purposes, like building infrastructure, while other times they are more general and can be used however the issuer sees fit.
The investor is the individual or institution that purchases the bond, thereby lending cash to the issuer. Sometimes there are intermediaries, like brokers from whom investors buy the bonds through, but from an investment standpoint, the issuer owes the investor.
Interest payments
Most bonds pay regular interest payments, known as coupon payments. The amount paid is based on the face value of the bonds — i.e., the amount invested — multiplied by the interest rate, i.e., coupon rate. For example, a $1,000 bond with a 5% coupon rate pays $50 per year. Those interest payments are often divided into two payments per year, also known as semiannual payments, which in this case would mean receiving $25 every six months.
There are nuances to calculating interest payments if you purchase a bond after it's been issued. However, if you buy a newly issued bond and hold it until it matures, the process typically follows this straightforward route.
Term to maturity
A bond's maturity is the length of time until the bond's principal is repaid and interest payments end, with this ending known as the maturity date. The term to maturity indicates how much time is left until the bond reaches its maturity date, as some bonds are purchased on the secondary market, after they've already been issued.
Bonds are grouped into three main categories, based on term to maturity, often as follows:
- Short-term bonds: Up to five years
- Intermediate-term bonds: five to 12 years
- Long-term bonds: 12 to 30 years
Maturities, also called durations, often correlate with an investor's risk/return appetite. Generally, bonds with longer maturities have higher interest rates, as issuers compensate investors for the longer commitment of their money. Sometimes a long maturity is risky, as there's more time for interest rates to change, which can influence bond prices.
"One of the disadvantages of bonds is that they are very affected by interest rates, so if you buy a long-term bond, you're going to be more subject to prices going up and down based on interest rates," says Luis Rosa, CFP and founder of Build a Better Financial Future, LLC.
Higher durations usually mean the bond price has a higher likelihood of dropping more as interest rates rise, which indicates higher interest rate risk. A bond with a three-year duration, for example, will often drop 3% in price as a result of a 1% increase in interest rates, since bond prices typically change about 1% opposite to interest rates for every year of duration.
That said, buy-and-hold bond investors don't necessarily need to worry as much about interest rate risk. While price changes affect returns if you need to sell early, if you hold until maturity you would still get the full principal repaid by the issuer.
Other key bond terms
Some other common bond terms to know include:
- Face value (par value): This is the amount that the issuer agrees to repay the bondholder at maturity, regardless of interest rate changes or bond price changes on the secondary market
- Coupon rate: The annual interest rate on a bond that is paid to investors in exchange for their loans.
- Bond yield: The bond yield is a measurement that shows the return you can get on a bond. While sometimes this equals the coupon rate, changes to the bond's current price affect the yield, because a $100 bond paying a 5% coupon has a higher yield than a $98 bond paying 5%. The simplest way to calculate a bond yield is to divide the bond's coupon by its current price.
- Rating: Rating agencies assign ratings to bond issuers based on their creditworthiness. These ratings can help you understand the risk. "Investment-grade" bonds, or bonds that hold a low risk of default, generally have a rating of Baa, BBB, or above. Note that different rating agencies have different rating scales.
Bond credit ratings explained
In the same way that credit scores indicate an individual's creditworthiness, bonds are evaluated by agencies to assess the issuer's ability to make interest payments consistently and repay the loan by its agreed-upon maturity date.
Ratings are based on the issuer's financial health, and bonds with lower ratings are known to offer higher yields to investors, to make up for the additional risk they're taking on.
The three main bond-rating agencies are Moody's, Standard & Poor's (S&P), and Fitch. Higher-rated bonds, also known as investment-grade bonds, generally hold a rating of "Baa" or "BBB" or above, based on the rating agency. This means the bond is viewed as less risky because the issuer is more likely to pay off the debt. The tradeoff, however, is often a lower yield.
S&P, Fitch, and Moody's investment-grade ratings
| Meaning | Moody's | S&P | Fitch |
| Almost zero risk | Aaa | AAA | AAA |
| Low risk | Aa | AA | AA |
| Risk if economy declines | A | A | A |
| Some risk; more if economy declines | Baa | BBB | BBB |
Bonds rated "BB" and below are considered "speculative," or "junk bonds." These issuers typically offer higher yield to offset the risk. It's worth noting that ratings are not set in stone. Agencies can update their ratings, and whether it's an upgrade or a downgrade can affect the bond's price.
S&P, Fitch, and Moody's non-investment-grade ratings
| Meaning | Moody's | S&P | Fitch |
| Risky | Ba | BB | BB |
| Expected to worsen | B | B | B |
| Probable bankruptcy | Caa | CCC | CCC |
| Probable bankruptcy | Ca | CC | CC |
| In bankruptcy or default | C | C | C |
| In bankruptcy or default | N/A | D | D |
Types of bonds
Bonds can come from many different kinds of issuers. Generally speaking, there are four main categories of bonds:
Corporate bonds
Corporate bonds are issued by companies looking to raise capital, such as to build out new facilities. Issuing these bonds often allows companies to obtain financing at a lower interest rate than if they took private loans, such as from banks. The risk and return levels for investors vary significantly based on the company's creditworthiness.
Government bonds
The category of government bonds typically means those that are issued by the U.S. Treasury on behalf of the federal government. But government bonds could also be issued by non-U.S. governments, and this category is also referred to as sovereign debt. Government bonds are often used to finance government programs when there's a federal budget deficit. U.S. Treasuries, in particular, are considered low-risk investments due to the creditworthiness of the federal government.
Interest income on U.S. Treasuries is typically exempt from state and local income taxes.
Municipal bonds
Municipal bonds are issued by states and local governments to finance everyday operations and projects like schools, highways or sewer systems. The credit risk and therefore interest rates of these bonds depend on the creditworthiness of the state or municipality issuing the bond. One advantage of municipal bonds, also called muni bonds, is that their interest income is exempt from federal income taxes, and sometimes state and local taxes too.
Agency bonds
Agency bonds are issued by departments within the federal government or government-affiliated organizations, like Freddie Mac. These bonds typically pay slightly higher interest rates than U.S. Treasury bonds because the credit risk can be slightly higher than Treasuries that have the full backing of the federal government.
Other bond types
In addition to these main categories of bonds, there are also some more niche types of bonds or similar fixed-income instruments, though these are often reserved for more advanced investors. For example, mortgage-backed securities repackage homeowners' mortgages into bond-like investable instruments.
Rosa advises investors to consider their risk tolerance when deciding which type of bond is right for them.
"If you are risk averse, you might want to invest in something a bit more secure, like U.S. treasuries that are backed by the federal government, and if you're in a higher tax bracket, you might want to consider municipal bonds, where you can get some tax-free income," says Rosa.
Why do people invest in bonds?
There are many reasons why people invest in bonds, either instead of or as a complement to other securities, depending on their situation. Some of the top advantages of bonds include:
Regular income
Bonds can provide regular income through interest payments on a fixed schedule. In contrast, stocks might not provide much or any income (depending on if they pay dividends), unless investors sell their stocks.
Meanwhile, the interest rates on bonds are often higher than the deposit rates offered by banks on savings accounts or CDs. Because of this, for longer-term investments where you want some security but still want to grow your portfolio, like when investing for college, bonds often provide a good balance of risk vs. return.
Capital preservation
Bonds generally have a lower risk of losing principal than stocks. If you hold your bond until maturity, then generally you'll get your full principal back, plus interest, whereas with stocks you might lose money. Even if the company goes into bankruptcy, bondholders have priority over stockholders.
Portfolio diversification
Investing in bonds can help diversify your portfolio and reduce risk. That's because stocks and bonds don't always move in sync, so sometimes when stocks are falling, like during an economic slowdown, bonds hold up better, due to falling interest rates boosting bond prices in the secondary market. And if you hold your bonds until maturity, you can still get your full principal back plus interest, which can help balance out periods where you don't want to sell stocks at a loss, like during a bear market.
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0.25% annual management fee
- Low-cost, 100% portfolio of diverse bond ETFs
- Great for those who want to invest in low-risk, short-term investments
- Earns a 5.50% yield
- Offers automatic dividend reinvesting, portfolio rebalancing, and tax-loss harvesting
- $500 minimum to open
- Bond ETFs generally have lower returns compared to other assets
- Charges a 0.25% annual management fee
- Blended 30-day SEC yield of 5.50%, after Wealthfront's advisory fee.
- Portfolio is fully managed.
Risks of investing in bonds
While bonds are often considered to have lower risk than stocks, that's not to say they have no risk. The category overall has some risks, and there can be significant variations of risk levels among different bonds. Some main risks include:
Interest rate risk
Bonds are subject to interest rate risk. If you're holding bonds while interest rates rise, then bond prices in the secondary market typically fall, as investors would want to pay less for those existing bonds when they could otherwise get newly issued bonds at a higher interest rate. And even if you hold your bonds, there's an opportunity cost vs. investing in newly issued bonds at a higher interest rate.
Credit risk
As the credit ratings show, there are significant variations in the risk of an issuer defaulting. The higher the credit risk, the more bonds typically pay.
Inflation risk
Because many bonds are fixed, aside from some like I-bonds that adjust based on inflation rates, there's a risk that purchasing power from bonds decreases due to inflation. For example, if you invest in a bond paying 3% interest per year, but then inflation rises to 4%, you could be effectively losing money, even though you're still getting that 3% in interest income.
Call risk
While less common, some bonds can be redeemed early if the issuer chooses to exercise their call option. This could affect your investment strategy, such as if your bonds are redeemed at a time when interest rates are down. Be sure to confirm whether any bonds you invest in are callable to assess whether you want to take on this risk.
How to invest in bonds
If you're ready to buy bonds, there are a few main ways to do so, such as:
Through a brokerage account
The availability of bonds varies by broker, but you may be able to buy individual bonds — either newly issued ones or existing bonds that are trading on the secondary market — through your brokerage account. You also may be able to buy bond funds through your brokerage account.
Directly from the U.S. Treasury
If you want to buy government bonds, you can create a TreasuryDirect account and purchase Treasuries directly through the government.
Bond ETFs or mutual funds
As mentioned above, another available option when it comes to buying bonds is investing in bond funds or bond ETFs that invest in a basket of underlying bonds, rather than you having to buy individual bonds. They may be subject to more interest rate risk since you can't buy and hold until maturity the way you can individual bonds, but bond funds can add benefits like greater liquidity.
Mutual funds are another option for investing in bonds. "They trade every day, so you don't have to wait until maturity if, for some reason, you do need your money," says Rosa, adding that they're professionally managed and offer more diversification than a single bond.
FAQs about bonds
How are bond prices determined?
Bond prices are determined based on factors such as interest rates, supply vs. demand of bonds, inflation, and credit risk.
What is a bond rating?
A bond rating refers to the creditworthiness of a bond issuer. The higher the rating, the lower the likelihood that the issuer will default, and therefore interest rates for highly rated bonds are lower than those for bonds that have a high risk of default.
How do I choose the right bonds for my portfolio?
Choosing the right bonds for your portfolio depends on analyzing factors like when you want your principal returned so you can determine the maturity, as well as assessing how much risk you are willing to take, which affects the interest rate you'll receive.
