What Are Bonds, and How Do They Work?

Bonds are issued by companies and governments. If you invest in a bond, you’re giving the organization a loan. Learn how it works.

What’s a bond?

You may have heard that bonds are safer to invest in than stocks. The reason that they’re recommended is that they have lower risk and volatility. So, what exactly is a bond?

Related: How to read a stock chart

A bond is a loan that’s made to a company or government by an investor. An organization issues bonds to raise money. It could be for projects or operating expenses. Regardless, the goal is to raise funds.

As an investor, bonds are fixed-income investments, and you won’t have ownership in the organization.

The money that you earn isn’t dependent on the performance of a company. Instead, the organization pays you a fixed interest rate. It’s a way to reduce risk and balance your portfolio.

How they work

There are two sides, the issuer, and the investor. The issuer can be a government, government-sponsored company, or corporation. The investor is also known as the bondholder, creditor, or debtholder.

When you purchase a bond, you agree to the terms, and you become the lender. The agreement will outline the following details:

• Coupon rate. The interest rate that’s paid by the issuer.
• Face or par value. The amount that the bond is worth at issuance.
• Price. How much the bond would cost on the secondary market.

Like other investments, risk and reward go hand-in-hand. With bonds, the lower risk also leads to lower interest rates. Since they’re relatively safe, it’s a great way to diversify your investments.

Types of bonds

While treasury and corporate bonds are the most common, they aren’t the only types of bonds. The following are the different types of bonds.

1. U.S. Treasury (T-bonds). A fixed-rate debt security issued by the U.S. Federal government. Being backed by the U.S. government, it has low risk and high credit quality. The drawback is that yields are lower than other types of bonds.

U.S. Treasury bonds pay a fixed rate of interest every six months until they mature. The term ranges from 20 to 30 years, and you can purchase them in multiples of $100.

The interest that you earn is exempt from state and local income taxes. However, it’s subject to federal income tax. You can purchase T-bonds through TreasuryDirect, a bank, or a broker.

2. Agency. A debt obligation that’s issued by agencies of the U.S. government or government-sponsored enterprises (GSEs). Generally, the yields for agency bonds are higher than T-bonds while also having high credit quality.

GSEs are subject to more credit and default risk than T-bonds because they’re public companies owned by shareholders. They’re not backed by the “full faith and credit” of the government.

The most common agency bond issuers are as follows:

• Federal Home Loan Mortgage Corporation (Freddie Mac).
• Federal National Mortgage Association (Fannie Mae).
• Federal Home Loan Banks.
• Federal Farm Credit Banks.
• Government National Mortgage Association (Ginnie Mae).

3. Municipal (Muni bond). A debt security issued by cities, counties, states, or another public entity. The funds are used to fund public projects, such as roads, schools, hospitals, sewers, airports, and seaports.

The benefits of investing in municipal bonds are the low level of default risk. Although municipal defaults can occur, the risk is lower than other types of bonds.

In most cases, the interest that you earn is also exempt from federal, state, and local income tax. However, it’s important to double-check with a tax professional.

4. Corporate. A debt obligation issued by corporations to raise funds for various reasons, including operations, expansions, pay dividends, refinance debt, or acquisitions.

Although you’re lending to a corporation, you don’t have ownership. If a company is very profitable or the stock price skyrockets, it doesn’t change how much you earn. You only receive the interest and principal on the bond.

There are many corporate bonds to invest in, as it makes up the majority of the U.S. bond market. The yields are also higher than T-bonds or other government-related bonds.

While the returns can be higher, it’s riskier. You must do your due diligence to ensure that it’s a good investment for you.

The biggest risk is if a company doesn’t make payments of interest or principal on time. If that occurs, the company will default on its bonds. Then, you’ll have a claim on the company’s assets and cash flows.

5. High-yield (Junk bonds). Bonds from issuers that have lower credit quality and pay higher interest rates. Typically, they’re issued by companies with high debt ratios.

Since high-yield bonds are more likely to default, they pay a higher rate to attract investors despite the risk. Most of them also have shorter maturities.

How to invest in bonds

Now that you know what bonds are, how they work, and the different types, you can begin investing in them. If you’re not sure about whether or not it’s a good idea for you, consult with a financial advisor.

You can buy bonds from a broker or directly from the U.S. government if you’re buying government bonds. To buy from the government, go to TreasuryDirect.

When you’re buying bonds, there are several things to consider. First, is the issuer trustworthy and able to repay?

Rating agencies rate bonds by giving a creditworthiness score. Look for bonds with higher ratings, such as AAA, which is the highest.

Second, look at your portfolio to figure out what bonds could benefit you. Think about how much risk you’re willing to take on, how much you want to earn, and the tax implications.

Lastly, consider the state of the economy. Bonds look the best when the economy and stock market are declining. This is due to the fixed interest rate.

When the economy and stock market are improving and doing well, the value of bonds may drop. This is because investors are focused on the high returns from the stock market.

Take a look at the rates that bonds are offering and research where the economy is and where it’s headed. It can help you figure out whether or not it’s a good time to buy a bond.

Frequently asked questions

Conclusion

Bonds can be great investments when you use them to diversify your portfolio because of the low-risk factor. Since the returns are lower than what you can earn with a stock, it’s important to balance your portfolio with a good combination of risk and reward.

Additional resources:

• How to invest in index funds
• Stock exchange hours around the world
• How much should I contribute to my 401(k)?

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