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Understanding Bonds: What They Are and How They Work
By Kristopher Kane MONEY RESEARCH COLLECTIVE
Bonds are lower-risk investment opportunities that allow investors to lend money to a borrower with interest. The borrower promises to make periodic interest payments and repay the face value of the bond at an agreed-upon future date. Typically, bonds are issued by businesses, governments and other entities that need to raise funds.
Bonds can be a good option for investors looking for consistent, predictable income. They also have the potential to provide capital appreciation returns on top of the interest and face value repayment. Keep reading for a look at the various types of bonds and the benefits and drawbacks of investing in them. We’ll also discuss why you might want to buy bonds and how they compare to other investment options.
Table of contents
- What is a bond?
- Types of bonds
- Pros and cons of bonds
- Why buy bonds?
- Bonds vs. other investments options
- What is a bond FAQs
- Summary of what is a bond
What is a bond?
A bond is an investment that allows an individual or larger entity — such as a trading brokerage — to invest in a corporation or government entity. It’s a financial arrangement where investors lend money to the bond issuer. In return, investors are promised regular interest payments over time and full repayment by the bond’s maturity date.
Bonds, like stocks and derivatives, are tradable financial instruments you can purchase on the secondary market. You can also buy new bonds through a broker or directly from the government. Because of this flexibility, bond investments are attractive to even the most risk-averse investors, as returns can come from the terms of the bond or from reselling it at advantageous terms.
How do bonds work?
Bonds work by securing financing for a corporation or government agency with the money paid by bond investors. When an investor purchases a bond, they provide the bond issuer with a loan at a fixed interest rate. The bond issuer promises to make regular interest payments at the agreed-upon rate until the date of the bond’s expiration.
Upon expiration, the bond issuer is also obligated to repay the bond’s full face value, regardless of whether the bondholder is the original investor or the bond was purchased from a private investor on the secondary market. A bond’s fair market value differs from its face value. The face value is determined at the bond’s issuance, whereas fair market value can fluctuate depending on a variety of factors.
Unlike the face or par value, which is fixed, the fair market value can vary significantly over the life of a bond. It can rise or fall as other market conditions make investing in secondary market bonds more attractive than purchasing new bonds.
Because investing in bonds brings regular interest payments over the life of the bond and full repayment of its face value when it matures, bonds are generally considered safer forms of investment than stocks, commodities or mutual funds. The bond market is generally not as vulnerable to market fluctuations.
Bond interest rates
Bond interest rates are set by the entity issuing the bond, which typically determines that rate after considering market conditions, inflation and the prime interest rate. The prime rate is the benchmark most creditors use when determining the interest they charge borrowers. A higher prime rate will generally mean bonds will pay higher interest rates, though inflation and other market conditions can affect this.
Interest on bonds is typically paid semiannually, usually in the spring and fall, though the terms of some bonds may differ. The annual interest paid on bond investments is calculated by multiplying the coupon rate, which is the interest rate set by the bond issuer, by the face value of the bond, which is an amount set by the bond issuer when the bond was first created. Coupon payments are the amount paid to bondholders for annual interest.
It should be noted that because private investors can sell bonds on the secondary market, a bond’s face value and selling price can differ considerably.
Types of bonds
The different classifications of bonds are relatively straightforward once you know what they mean. With the exception of zero-coupon bonds, which are sold at deep discounts but pay no interest, bonds can be categorized in a couple of different ways depending on the issuer, such as the distinction between corporate and municipal bonds. Those categories can then be further divided into subgroups depending on the bond’s inherent level of risk or its intended use.
Corporate bonds
Corporations issue corporate bonds to raise money to finance day-to-day operations, research and development or other business expansion needs.
Investment-grade
Investment-grade bonds are considered relatively safe investments with a low level of default risk. These bonds have a credit rating of BBB- or higher issued by rating agencies such as Standard & Poor’s (Baa3 for Moody’s), which are considered authoritative and reliable. A BBB- bond rating or higher generally indicates that the company has a good chance of continuing viability with no risk to operations and good to excellent creditworthiness.
Before granting a bond rating, the rating agencies review a bond issuer’s financial fundamentals, debt and other key performance indicators. If these factors are assessed to be sufficient to protect against the risk that the bond issuer will require extraordinary assistance — such as bankruptcy protection — to avoid defaulting on its issued bonds, the bond is rated BBB- or higher.
A BBB- rating doesn’t guarantee a bond’s viability, and negative business or economic developments can cause a change in the issuer’s ability to repay the bond’s full face value.
High-yield
High-yield bonds, also known as junk or speculative bonds, are bonds with a credit rating of BB+ or Ba1 or lower. These bonds have higher yields but also have higher default risks. A rating of BB+ or Ba1 (depending on the rating agency) indicates there’s a greater chance that the bond issuer may default on the bond, mainly due to adverse market developments or events impairing the company’s ability to operate at a profit.
Just as a BBB- rating is no guarantee of solvency, a BB+ rating indicates that while there is higher default risk, a company does possess sufficient cash flows and financial flexibility to support honoring financial commitments.
Municipal bonds
Municipal bonds, also called “munis,” are issued by local governments and municipalities to finance public projects. These bonds are typically tax-exempt, meaning the interest earned on the bond is generally not subject to federal or local taxes. Municipal bonds come in three main categories: general obligation, revenue and conduit bonds.
General obligation bonds
General obligation bonds are typically used to finance the regular day-to-day operations of the government body issuing them, such as funding emergency services, constructing and maintaining roads and bridges, constructing and upkeep of schools and other public buildings and costs related to other public infrastructure.
These can also be used to fund long-term bond investments, such as the purchase of land for the construction of government buildings, affordable housing or other public works facilities. They could also be used to pay for major capital projects like alternative energy or wastewater treatment plants.
Unlike other forms of debt, general obligation bonds are not secured by specific assets. The issuer instead agrees to pay back the debt with the revenue raised from taxation.
This amounts to a form of guarantee, as it means the issuer is obligated to raise taxes if necessary to repay the debt. Typically, general obligation bonds are considered one of the safest forms of bond investment since the issuer essentially guarantees repayment.
Revenue bonds
Revenue bonds are a type of municipal bond issued by local or state government backed by a dedicated stream of revenue from a specific source. Such guaranteed sources of revenue can be things like airport landing fees, bridge tolls, HOV lanes or turnpikes, fees charged by public utilities and general tax revenue from specific districts.
These bonds are typically used to finance projects such as public infrastructure, schools, hospitals or other municipal facilities like fire stations. Because revenue bonds provide investors with a steady and reliable income stream, they’re seen as relatively low-risk investments and can be an excellent option for investors looking for a steady, predictable return.
Conduit bonds
Local governments issue conduit bonds to finance private projects, such as building a not-for-profit hospital, a public business park or constructing new public infrastructure, such as a rail line or affordable housing.
The local government issues bonds to raise funds for the specific project, and the bondholders, in turn, receive regular interest payments on their investments.
The municipality issuing the bond is responsible for repaying the debt in full, usually with the revenue generated from the private project being used to pay off the bondholders.
Like other municipal bonds, conduit bonds are often seen as an attractive investment for those looking to generate income from a secure and low-risk investment.
U.S. Treasuries
In addition to the revenue raised by taxation, the U.S. government issues U.S. Treasury bonds to finance its day-to-day operations. These bonds are considered one of the safest forms of investment since they are backed by the full faith and credit of the federal government.
Treasury bonds come in two main categories: treasury bills or treasury notes. Treasury bills — or T-bills — are short-term bonds typically sold in denominations of $1,000, lasting from four to 52 weeks. Treasury notes are medium-term bonds with durations of two, five, seven or 10 years.
Though it’s a bit more complicated for the new bond investor, the Treasury also issues securities known as Treasury Inflation-Protected Securities (TIPS). TIPS are indexed to the rate of inflation to protect investors from a decline in the currency value over the life of the bond. The interest rate on a TIPS bond is fixed, but as inflation changes, the price or principal amount of the bond is adjusted, which causes the interest payments to vary because of the adjusted principal amount.
Pros and cons of bonds
Pros:
- Income: Bond investments provide a steady income from interest accrued
- Capital appreciation: Some bonds have the potential for capital appreciation returns
- Low-risk investment: Bonds, especially municipal bonds, are typically a much lower-risk investment than stocks
- Tax advantages: Investing in municipal bonds provides significant tax advantages — they may be exempt from federal and state taxes
- Portfolio diversification: Low-risk municipal bonds are an excellent avenue of diversification for stock portfolios with more volatile investments
Cons:
- Lower return risk: Bonds may have lower potential returns compared to stocks
- Interest rate risk: Rising interest rates may cause bond prices to fall and, conversely, decreasing interest rates can cause bond prices to rise
- Default risk: In the case of corporate bonds, principal investments may not be repaid in full if the bond issuer defaults
- Inflation risk: Higher inflation causes the purchasing power of a fixed-rate bond to fall
- Liquidity risk: Bonds are less liquid than stocks, so selling it before it reaches maturity may be more challenging but still possible
- Bonds are callable: If interest rates fall, the bond issuer has the option to “call” the bond, forcing investors to reinvest at lower rates
Why buy bonds?
Investing in bonds is an excellent way to diversify and protect your money from the stock market’s fluctuations while receiving regular payments at a fixed interest rate. With a bond portfolio, you have the potential to earn a steady income over time through predictable longer-term interest payments. Depending on the type of bond you own, you may also receive tax advantages.
When you own bonds, you are lending money to the issuer, such as a government or corporation, in exchange for an IOU, a promise that they will pay you back the principal plus interest at the end of the bond’s term. This makes it possible to receive a return on your investment that is largely unaffected by changes in the stock market, making it a great way to hedge against risk.
If the issuer’s financial situation improves, the bond’s fair market price may rise, allowing you to realize capital gains in addition to the regular interest payments. You can benefit from steady income and potential capital appreciation while creating a stable and versatile investment portfolio with bonds.
Bonds vs. other investments options
Bonds are a popular investment choice for a variety of reasons. They’re an attractive way to diversify a portfolio by reducing its overall risk exposure, especially in the case of municipal or government bonds. They’re often considered safer investments than stocks, commodities or mutual funds, as their returns are generally more predictable and stable.
Investing in bonds can potentially provide a higher return on investment than other fixed-income securities, such as certificates of deposit (CDs). They can be more liquid than other large investment opportunities, such as real estate.
Like other asset classes such as stocks, bonds can also be bought and sold on the stock market, which is referred to as the secondary market when referencing the resale of bonds. Also called the aftermarket, this is where investors trade securities they already own.
Compared to most other forms of investment, bond investments are seen as a wise way to create a balanced portfolio, as their lower risk and guaranteed returns can provide an excellent counterpoint to riskier investments.
What is a bond FAQs
What are the benefits of investing in bonds?
Investing in bonds typically provides a steady, predictable income for the life of the bond and the guaranteed return of the principal investment. Bonds are a good option for risk-averse investors looking for reasonable returns without the risk of loss commonly seen with most stocks. Bonds also have the potential for capital appreciation, which is when a bond increases in value.
What are some popular bond investing strategies?
There are many different ways to invest in bonds. Some popular strategies include laddering bonds, buying individual bonds or investing in bond funds or exchange-traded funds (ETFs). Laddering bonds involves investing in bonds with different maturity dates, which allows you to spread out both the risk and benefit from a predictable income stream.
When buying individual bonds, it's important to research the issuer and review the specific terms of the bond to understand potential return and credit risk. Bond funds and ETFs provide a more diversified approach to investing in bonds, allowing investors to benefit from a larger pool of bonds with different maturities, credit ratings and yields.
How do interest rates impact bond prices and returns?
Changing interest rates and bond prices have an inverse relationship, meaning when one goes up the other tends to go down and vice versa. So, when market interest rates go up, the value of existing bonds decreases, and lower interest rates increase bond prices. And since bonds generally pay interest at a fixed rate, investors are more likely to buy newly issued bonds with higher interest rates.
What is a bond's duration, and how does it affect the risk of a bond investment?
A bond's duration is the length of time until an issued bond reaches maturity — the date the borrower must repay the principal investment. It's an important factor to consider when investing in bonds, as longer-duration bonds may provide payments over a longer period, but the overall return is more sensitive to changes in interest rates.
As a result, longer-duration bonds tend to be riskier than shorter-duration bonds because if interest rates rise, the prices of longer-duration bonds typically fall more than those of shorter-duration bonds. It's important to note if interest rates decrease, prices of longer-duration bonds tend to rise more than those of shorter-duration bonds.
How do tax laws impact the returns on bond investments?
Depending on the type of bond, tax laws can significantly impact an investor's returns. Investors need to be aware of the tax implications when investing in bonds and consider how they may affect their investment returns when weighing the pros and cons.
Municipal bonds, which state and local governments issue, are attractive to some investors because they're tax-exempt. Interest earned on a municipal bond isn't subject to federal or local taxes, allowing investors to maximize their potential returns without worrying about taxation. Corporate bonds typically are subject to taxes, with the amount of an investor's liability depending on the type of bond and the investor's tax situation.
Summary
Bonds can be a great way to diversify your portfolio and protect your money from market volatility. When investing in a bond, you’re loaning money to a borrower in exchange for regular interest payments over a period of time and a generally guaranteed return on your principal.
Corporate bonds, such as high-yield or junk bonds, bring higher risk due to the chance that the borrower may default and fail to repay the total promised amount. But investment-grade corporate bonds are generally safe bets.
Bonds are a way to invest in federal, state, or local governments as well as corporations. Because bonds can be bought and sold on the secondary market, they’re a more flexible investment opportunity than less liquid investments like real estate.