What Are Bonds and How Do They Work?

A bond, which is often referred to as a fixed income investment, is a loan you make to the government or a corporation when they need to raise money. Think of a bond as an IOU. In exchange for loaning the government or corporation money, they promise to pay you periodic interest payments during the life of the bond and repay you the face value of the bond once it matures.

Issue price: The issue price of a bond is the original price that an investor bought a bond at. There are three scenarios for the issue price of a bond. 1) The bond can be issued "at par" which means the bond is issued at face value (see below).

2) The bond can be sold at a discount which means that the bond is issued at a price lower than the face value of the bond. 3) The bond can be sold at a premium which means that the bond is issued at a price that is higher than the face value of the bond.

Face value: This is the amount of money that the bond will be worth when it matures on the maturity date. Many bonds have a face value of $1,000. The face value of a bond is different than the issue price of a bond. An investor could buy a bond at a discount for $950, or at a premium for $1,050, but will still receive $1,000 when the bond matures - which is the face value of the bond.

Coupon rate: The coupon rate is the interest rate that a bond will pay on the face value of the bond. For example, a bond might have a 5% coupon rate. If the face value of a bond is $1,000, it would pay out $50 in interest payments ($1,000 x 5% coupon rate).

Coupon dates: The coupon dates are the dates that the bond issuer (either the government or corporation) will make interest payments. Bonds will typically pay interest twice per year.

Maturity date: The maturity date is the date on which the bond "matures." This is the date in which the government or corporation that issued the bond repays the face value of the bond back to the investor.

Bonds are often referred to as debt instruments. When a company, or government entity needs funding to maintain operations, or develop new projects, they will issue bonds to investors in order to raise money for these purposes.

When you purchase a bond, that company or government entity will take the money and use it for a variety of purposes. In exchange for making the loan, you as the investor will receive periodic interest payments during the term of the bond (usually twice per year), as well as the face value of the bond upon maturity. 

Bonds are typically priced at face value, or par, when they are first issued. Par value is usually $1,000 per bond. However, the market value of bonds can change after they are issued due to the credit quality of the bond, the length of the bond, and interest rate changes.

For example, you could buy a bond at face value for $1,000 and sell it a year later above or below this value to another investor before the bond matures. In other words, you do not typically have to hold onto a bond until it matures. You can sell it to another investor. We will look at how the market value of bonds can change later on.  

Corporate bonds are issued by corporations in order to raise capital. In some cases, issuing bonds can be a better way for a corporation to finance operations as opposed to obtaining financing through a traditional loan from a bank or financial institution.

Municipal bonds are issued by states and local munipalities. These bonds are issued to fund day to day operations for the states and municipalities, or to fund projects such as building schools. In general, the interest earned from municipal bonds is exempt from federal tax. Interest earned may also be from state tax if you live in the state in which the bond is issued.

Government bonds can be thought of as national government issued bonds. These bonds are ofter referred to as "treasuries" as they are often issued by the US Treasury. Government bonds that mature in a year or less are called "bills" or "T-bills."

Government bonds that mature between 1 and 10 years are called "notes." Government bonds that mature in more than 10 years are called "bonds."

Agency bonds are bonds that are issued by government sponsored enterprises (GSEs) or US government agencies. For example, Fannie Mae and Freddie Mac, which are privately owned corporations in the housing sector that were created by the federal government, offer agency bonds.

The first way you can make money with bonds is through the semiannual interest payments. Bonds pay interest based upon the face value or par value of the bond, and not the current market price of the bond. For example, if you bought a bond with a face value of $1,000 that had a coupon rate (interest) of 4%, you would earn $40 in interest payments per year ($1,000 x 4%).

The second way that you can make money from a bond is selling it to another investor for a profit or buying a bond below face value and holding it until maturity. Remember, the face or par value is simply the amount of money that the bond will be worth when it matures.

The par value of a bond never changes. However, the market price of a bond can change based upon a variety of factors (we will look at that in the next point). For example, you could buy a bond at face value (typically $1,000) and sell the bond to another investor at $1,100 for a profit of $100 if the price of the bond goes up.

The flip side of this is that you could buy a bond below face value and hold it until maturity. For example, lets say that the face value of a bond is $1,000. If you bought that bond at a market price of $950 and held it until maturity, you would get $1,000 and be left with a profit of $50 since the face value of a bond does not change.

The price of a bond has an inverse relationship with interest rates. If interest rates go up, bond prices typically fall, and if interest rates go down, bond prices typically go up. For example, lets say you bought a bond at face value (which would equal $1,000) and it paid a coupon rate (interest) of 4%.

However, after you bought that bond interest rates rose to 5%. Most likely, the price of that bond would drop below $1,000. Why is this exactly? If another investor can get the same bond that you did, but with a higher coupon rate, it becomes more attractive to investors.

Hence, the price of the bond you bought will drop in order to equalize the difference between the coupon rate that you bought the bond at, and the coupon rate that bonds are currently at. Conversly, if interest rates go down, the price of a bond typically goes up.

Lets use the same example as before. You bought a bond at face value and it paid a coupon rate of 4%. If interest rates dropped to 3%, the price of your bond will likely increase. Why is this? Since interest rates have dropped, the higher coupon rate that you bought your bond at makes your bond more attractive to investors and drives up the price.

Keep in mind that there are other factors besides interest rates that can affect the price of bonds. First, the credit qualify of a bonds issuer can impact what the price of a bond will be. Standard & Poor's Global Ratings, Moody's, and Fitch Ratings are rating agencies that rate the overall quality of a bond.

Bonds are given a rating by these agencies when they first issue. However, after a bond issues, the rating that the bond receives is subject to change based upon the agencies rating methodology. If a rating agency decides to downgrade the rating that it initially gave a bond when it issued, the price of that bond can go down.

Higher rated bonds are considered to be "safer" and generally pay a lower coupon or interest rate. Lower rated bonds are considered to be "riskier" and generally pay a higher coupon or interest rate to compensate for this. Ratings provided by these agencies can give you a general idea of the quality of the bond that you are looking to invest in, but it is not a good idea to buy a bond solely based upon a credit agencies rating.

A secondary factor that can affect the price of a bond is how close the bond is to maturity. If you hold a bond to maturity, you are going to receive the face value of that bond. As the bond gets closer and closer to mature, the price of the bond tends to move towards the face, or par value of the bond- whether that means the bond going up or down in value.

Less volatile than stocks - in the short term

Volatility simply measures how much the price of an asset fluctuates over a particular period of time. In general, bonds tend to be less volatile than stocks (in the short term), which can make them more attractive if you have a low risk tolerance.

Now of course this does not means bonds are never volatile. Over the long term, bonds can end up being volatile due to interest rate risk (which we will look at in the next section). However, in the short term (think 5 years or less), bonds tend to not be as volatile as stocks.

Interest payments

Since bonds pay out semiannual interest payments, they can create a stream of income. The interest that bonds pay can create a reliable income stream which can make bonds more attractive to investors who don't want to take on as much risk - such as retirees.
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Liquid

In general, bonds are considered to be liquid assets as you can buy and sell them on the secondary market farily easily. Bonds are less liquid than stocks, but if you invested in a good bond, you will typically be able to sell it to another investor if needed.

Lower returns than other assets

There is a trade off for the "safety" of bonds - your return will be much lower than other assets (especially stocks). Depending on the data that you look at, the historical return of bonds has been about 5% to 6% annually, where the historical return for stocks has been about 10% annually. Positive returns do not happen every year.

Credit risk

Credit risk is the risk that the issuer of the bond cannot repay the obligations of the bond. Remember that credit agencies rate the quality of a bonds issuer. If the bond has a higher credit rating, it is generally considered to be "safer" as the issuer of the bond is more likely to be able to repay the obligations of the bond.
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Interest rate risk

Due to the inverse relationship that bond prices have with interest rates, bonds carry interest rate risk. If you bought a bond, and afterwords interest rates rose higher than the interest your bond earned, the price of your bond would go down because it is not as attractive to investors.

Inflation risk

Since bonds have a lower return than other asset classes, they carry inflation risk. Inflation risk is when the total return for a bond is less than the rate of inflation. In this situation, bonds are not an ideal investment as your dollars are becoming less valuable.

If you are an every day investor, you will most likely invest in three assets: stocks, bonds and cash or cash equivalents. If this is the case, it is important to understand how bonds fit into your portfolio. Bonds are used in portfolios to offset some of the risk that comes from investing in stocks, and to provide a steady stream of income.

Stocks will provide higher returns than other asset classes, but prices fluctuate more often which make them a higher risk investment. Since bonds tend to be less volatile, holding them in your portfolio can offset some of the volatility of stocks.

You can hold cash in your portfolio for liquidity, but bonds can provide higher returns than some cash equivalents and are still fairly liquid. Ultimately, bonds can play an important part in an investment portfolio, but it is important to make sure you have an investment portfolio that is best for you and your goals.

The short answer is that it depends. We just looked at how bonds fit into an investment portfolio. However, a better question to ask yourself is how bonds should fit into your investment portfolio? After all, you want to make sure your investments are best suited to help your reach your goals and not someone else's goals.

There is no exact answer on how bonds should fit into your portfolio, but there are a couple things that you can think through. First, you should understand your risk tolerance. Simply put, risk tolerance is the amount of risk that you are willing to accept as an investor.

If the idea of losing money from investing makes your stomach church, you probably have a lower risk tolerance. If you are completely fine with the possibility of losing money in exchange for the potential of higher returns, you probably have a higher risk tolerance.

If you have a low risk tolerance, you might want to allocate more of your portfolio towards bonds than an investor with a high risk tolerance that would allocate more of their portfolio towards stocks. Secondly, you should consider your age and investing time horizon.

Your investing time horizon is the amount of time that you have to reach an investing goal, or the amount of time you have until you would need to access your investments. For example, if you are 30 years old and are investing for retirement at 65, you have a 35 year time horizon.

Your age and time horizon can help you determine how much of your portfolio should be in bonds. If you have a longer time horizon, you can allocate more of your portfolio towards stocks and less towards bonds. Why is this exactly?

Since you have such a long time horzion (35 years), you can afford to take on more risk in exchange for higher returns by allocating more of your investments towards stocks and less towards bonds since the stock market tends to recover from crashes given enough time.

On the flipside, if you have a shorter time horzon, you might want to allocate more of your portfolio towards bonds to minimize volatility since you have less time to recover from a stock market crash or correction. Lets say that you had started saving for retirement at age 35 and you are now 55 years old.

You plan on retiring at 65, and therefore only have 10 years left until you retire. It could be a good idea to allocate more of your portfolio towards bonds and less towards stocks as you can't afford to take on as much risk as you might not have enought time to recover if something goes wrong.

Important note: The information above is only meant to serve an educational role and should not be taken as strict financial or portfolio allocation advice. We always recommend speaking with a licensed financial advisor to understand if bonds are a good investment for you.

There are three ways that you can buy bonds.

1. Buy bonds through a broker - A broker simply allows you to buy and sell a range of financial assets (including bonds) with other investors. If you don't yet have a preferred broker, you can check out our picks for the best online stock brokers.

2. Buy bonds through the US Government - If you are purchasing a government bond, you can buy it directly through the Tresury Direct website instead of buying them through a broker. These can save you on brokerage commission fees (although most online brokers don't have them anymore).

3. Purchase bond mutual funds and ETFs - If you don't want to be burdened with choosing individual bonds, you could opt to buy bonds through a bond mutual fund or ETF. A bond mutual fund or ETF owns hundreds or even thousands of bonds all at once.

Essentially, a bond fund will allow you to gain more exposure to a wide variety of fixed income investments which can be advantageous in certain situations. Bond funds can typically be bought through an online broker.

You need an investing account to buy bonds - You are going to need an investing account to buy bonds, unless you are buying them directly through the US Treasury website in which case you need a TreasuryDirect account.

With that exception, you are going to need a brokerage account to buy bonds. A brokerage account simply holds all of your investments and is not an investment itself. You can open a brokerage account through an online broker.

The application process is pretty straightforward. Go to the website of your chosen broker, and click to open a brokerage account. Submit the necessary information, wait for approval, transfer funds from your bank account and then buy your desired bonds.

Although you can start with a brokerage account when buying bonds, there are a wide variety of investing account types availble depending upon your goals. You can check out our post on the best investing accounts to learn more.

The bottom line is that bonds are debt obligations issued by corporations or the government to investors when they need to raise capital. Bonds are often considered to be a safer and more stable investment as they don't tend to be as volatile as stocks. Due to this safety, bonds typically have lower returns than stocks.

As an investor, you can make money with bonds by collecting semi annual interest payments, and by selling bonds to other investors for a profit. Bonds are typically used in an investing portfolio to offset some of the volatility that can come from stocks.

So, should you invest in bonds? It really depends. Your age, risk tolerance,and investing time horizon can all come into play. If you need help figuring out if bonds are right for you, we recommend speaking with a licensed financial advisor. If you want a broad overview on how to start investing, check out our beginners guide on how to invest.