Bonds are one of two securities many investors include in their portfolios. Although bonds may not get as much attention from average investors as stocks, the value of the global bond market exceeds that of the world stock market. Investors are drawn to the regular interest payments and relatively low risk of bonds to help offset the more volatile returns on stocks.
Bonds are issued mainly by two types of borrowers: governments and companies. These entities use bonds as they would a loan—to gain a cash infusion to meet current or long-term needs. In return, the bonds pay the lender interest over time and guarantee to refund their original investment, known as the principal.
Types of bonds
Bonds finance the needs of governments of all sizes and of corporations worldwide. There are many varieties of bonds, including:
The U.S. Treasury issues bonds known as “Treasuries” to pay for public projects and refinance existing federal debt. These bonds span maturities from a few days to 30 years and are categorized according to their maturity and other features:
- T-bills. These short-term securities mature in a few days to 52 weeks.
- T-notes. Medium-term T-notes mature in two to 10 years.
- T-bonds. This long-term debt matures in as long as 30 years.
- TIPS. Treasury inflation-protected securities are indexed to inflation and are sold in 5-, 10-, and 30-year maturities.
- FRNs. Floating-rate notes carry interest payments that can change over time. They are indexed to the 13-week T-bill and mature in two years.
So-called “munis” finance the daily obligations and long-term projects of state, local, county, and other municipal governments. They are structured either as general obligation or revenue bonds, depending on the type of project they fund.
Federal agencies other than the Treasury, along with some quasi-governmental institutions, issue these bonds, sometimes called “agencies” to fund public needs.
These bonds, referred to as “corporates” by traders, are issued by companies. They provide a business with ready cash or funding for longer-term projects.
Companies and governments worldwide issue bonds to meet the needs described above.
How to buy bonds or bond funds
Investors must have a brokerage account or access to a broker or financial professional to buy most bonds or bond funds, just as they do to buy stocks. The U.S. Treasury is one exception, because it sells its marketable securities in denominations of as little as $100 directly to investors on the TreasuryDirect website.
An investor who wants to buy an individual bond usually has two options. They can try to buy the bond in the primary market when the borrower first issues it. Or (what happens most often) they can purchase bonds on a secondary market, known as over the counter. These bonds have been sold by the original buyer before their maturity date. Thousands of broker-dealers buy them and trade them among themselves or sell them to investors.
Here are the differences depending on where the investor buys a bond:
New issues or primary market
Buying newly issued bonds is generally more complicated than buying them in the secondary market from a broker-dealer. However, investors can benefit from getting the new issue price, rather than paying the price and commissions charged in the secondary market. Investors can buy most bonds on the primary market, including:
- Corporate bonds. Buying new issue corporate bonds is like buying stock in a company’s initial public offering—it may be difficult without a relationship with the bank or brokerage managing the offering. Investors who succeed need a brokerage account with funds to cover the price and any broker commissions.
- Municipal bonds. Buying new issue munis requires a brokerage account with the financial institution backing the bond issue. Investors enter a request that indicates the quantity, interest rate, and maturity date of the bond they desire.
- Treasuries. Investors can buy new issue government bonds through Treasury auctions by placing a competitive or non-competitive bid. A non-competitive bid means the investor accepts the auction terms. A competitive bid specifies the investor’s desired yield and other requirements and may give the investor all, part, or none of their request.
Bonds don’t trade on centralized exchanges, as stocks do. Instead, dealers and institutions buy them when they’re first issued and trade them in secondary markets. Proceeds go to the counterparty—the current owner—instead of directly to the issuer.
- Corporate bonds. Investors can buy corporate bonds through an online brokerage or trading platform. Bond sellers provide the bond’s details including price, interest rate, and their order requirements. Investors can also buy and sell corporates through a full-service broker or investment professional.
- Municipal bonds. The muni bond secondary market is not a formal market. There are no public listings and no regular trading hours. Investors must open an account with a firm that deals in bonds. They would then buy from sellers who buy from other investors, dealers, banks, and brokerages.
- Treasuries. The Treasury Department doesn’t sell securities in the secondary market. Instead, primary dealers buy the bonds at auction and offer them to other investors or trade them among themselves. Investors can buy Treasuries at the TreasuryDirect website without paying a commission.
Investors who want regular interest and the low risk of fixed-income investing but don’t want to bet on the performance of an individual company or government entity might choose a bond mutual fund or exchange-traded fund. Bond funds also are more liquid, meaning they’re easier to buy and sell, than individual bonds. Bond funds come in many forms, including:
- Mutual funds. Mutual funds bundle many bonds into a single security. Some funds group bonds based on specific classifications or maturities. For instance, investment-grade bond funds invest only in high-quality bonds, while high-yield funds choose lower credit quality securities with potentially higher returns. Mutual funds provide greater diversity than investing in individual bonds. Because most are actively managed, meaning an investment professional selects the bonds to include in the fund, they often charge fees and commissions that can cut into returns.
- ETFs. Bond ETFs are similar to mutual funds in that they also hold a basket of bonds with various strategies and maturities. Bond ETFs are passively managed and trade like stocks on major equity exchanges. Many simply track benchmark indexes and are likely to have lower fees than actively managed mutual funds.
- Balanced funds. This type of mutual fund or ETF, also called a hybrid fund, offers a mix of stocks and bonds in a single security. These funds offer a blend of stocks to bonds geared toward specific needs based on certain time frames. They generally increase bonds and reduce stocks as the investor approaches retirement age. Some funds make the adjustment automatically.
Questions to ask before buying bonds
How do investors make money with bonds?
Investors can profit from bond investments in two ways. They can hold the bond to maturity and collect the full interest payments and principal. Or they can sell the bond before it matures at a higher price than they paid for it.
How do bonds fit into an investment strategy?
Investors tend to choose a mix of stocks and bonds based on their risk tolerance and stage of life. Individuals seeking growth might choose a larger percentage of stocks because of their historically higher returns. Those nearing retirement age might opt for more bonds and the peace of mind a fixed income can bring. A portfolio of stocks and bonds balances higher returns against reduced risk.
What happens to bonds when interest rates rise?
Bond prices typically move in the opposite direction of interest rates. When rates rise, bond prices fall. The shorter a bond’s maturity, the less the price will move and vice versa. The most volatile bonds usually are those with maturities of 20 years or more.
What are the pros and cons of bonds compared to stocks?
One big difference between stocks and bonds is the level of risk versus the returns each offers. Here are some potential pros and cons of bonds compared to stocks.
Potential benefits of investing in bonds
- Regular income. Investors gain by locking in a predictable source of income and the repayment of their principal.
- Lower risk. Bonds are less risky than stocks, where investors can lose much of or even their entire investment. Treasury bonds are essentially risk-free.
- Tax advantages. Treasuries are generally exempt from state and local taxes. Munis are usually not taxed federally and can be free from state and local levies.
Potential risks of investing in bonds
- Lower returns. Bonds historically have provided lower returns than stocks.
- Inflation/interest rate risk. Bond prices fall when rates rise. Inflation hurts investors relying on a bond’s fixed interest payments, which lose purchasing power as consumer prices rise.
- Less liquid. Bonds are less liquid than stocks and may not be easy to sell at a desired price. An issuer might retire, or “call,” a bond before its maturity —depriving an investor of the expected income stream—or fail to make the expected payments and default.
The bottom line
Many investors include bonds in their portfolios. The relative low risk and regular interest payments of bonds can counter the volatility of stocks. Investors can buy individual bonds when they’re first issued or afterward when they trade on secondary markets. Bond mutual funds and ETFs bundle a basket of bonds into one security, providing diversification and more liquidity than individual bonds. Investors can buy bonds through online brokers or financial professionals, while Treasury bonds are available on the Treasury’s website.