What Are Bonds & How Do They Work?

A person who needs cash can simply ask a bank for a loan. However, companies and governments don’t have to go to a bank—they can issue a debt security known as a bond.

A bond is a loan made to a corporation or government entity. Instead of getting funds from a bank or elsewhere, the company or other borrower raises money from investors who buy its bonds. The bonds act like an IOU, outlining the loan’s details and how and when the borrower will repay the debt.

What is a bond?

A bond is an agreement between a borrower and a lender. Although bonds vary in countless ways, they share some general characteristics:

• They pay the bondholder a regular, established return over a stipulated period, called the time to maturity.
• The bondholder gets back the full amount of their original loan, known as principal or face value, at the end of that time.
• Bond values rise or fall in opposition to changes in interest rates: When rates rise, bond prices fall and vice versa.
  

Companies, municipalities, states, federal governments, or agencies issue bonds for several reasons. The issuer immediately gets money to fund projects, increase cash flow, or finance existing debt. The process is efficient, and a bond often offers longer time horizons and more favorable terms than a bank loan.

5 Types of bonds

Bonds fall into five main categories.

1. Corporate bonds

Companies use bonds to finance operations and raise capital for projects. They are issued in blocks of $1,000 and generally have a standard coupon payment structure.

2. Treasury bonds

The U.S. Treasury Department issues Treasury bonds, or T-bonds, to finance federal government spending or the country’s debt. The term “Treasuries” describes all types of US sovereign debt across all maturities:

• Short-term T-bills have terms of a few days up to 52 weeks
• Medium-term T-notes are issued for two to 10 years
• Long-term T-bonds mature in as long as 30 years
  

The US insures Treasuries, making them virtually risk-free. The Treasury also issues savings bonds to US citizens who pay a fixed or an inflation-adjusted rate for up to 30 years.

3. Municipal bonds

Local and state governments issue so-called munis to fund daily obligations or finance big projects. General obligation bonds raise immediate capital for expenses while revenue bonds fund infrastructure such as roads and parks.

4. Agency bonds

Departments of the federal government other than the Treasury issue agency bonds, which like Treasuries are backed by the US government. They fund projects related to public needs. Quasi-governmental entities like mortgage lender Freddie Mac issue government-sponsored enterprise (GSE) bonds, which enjoy less federal backing.

5. Business bonds

Bonds can also protect a business. These are known as business bonds, commercial bonds, and commercial surety bonds. State laws may require them in certain industries or professions to guarantee some aspect of an owner or employee's occupation.

Understanding bond characteristics

Investors can assess and compare bonds by understanding their attributes.

Principal

A bond’s principal, also called face value or par value, is the dollar value of a bond when it’s issued. This is also the amount the holder will get when the bond matures. Principal is generally set in $1,000 denominations.

Coupon

Coupon refers to the interest the bond pays between its issue date and the date of maturity. Interest is usually paid at predetermined semiannual or annual intervals. The name derives from the days when bonds were issued as paper certificates, with coupons the holder would clip and send to the issuer for payment.

Maturity

A bond’s maturity is the length of the loan and the time when the issuer must repay the principal. The term of maturity is set when the bond is issued.

Price

After a bond is issued it generally trades over the counter in a secondary market. The price of the bond fluctuates in the market based largely on supply and demand and interest rates, while the face value remains fixed. The bid price is the highest amount a buyer will pay; the ask price is the lowest price a seller offers.

Rating

Agencies rate bonds and their issuers on their creditworthiness. Ratings indicate the bond’s risk. Investment-grade bonds have the highest ratings and least risk; below-investment grade bonds, called high-yield or junk bonds, have higher risk but generally better returns.

Yield

Yield is the return an investor realizes on a bond. It’s calculated in numerous ways and is expressed as a percentage. Each method provides a differing view of a bond’s risk and return.

• Running yield.

  This measures a bond’s annual return as a percentage of its price, rather than its face value. It shows investors what return they can expect in the current market. Running yield, also called current yield, is calculated by dividing the coupon by the market price.
  

• Nominal yield

  . Sometimes called nominal rate or coupon yield, this is the interest rate the bond issuer promises to pay. Nominal yield is also the bond’s coupon rate. It is fixed and applies to the life of the bond.
  

• Yield to maturity.

  This is the total rate of return a bond will have earned when it makes all interest payment and repays the principal. It can be seen as the bond’s internal rate of return
  

• Tax-equivalent yield.

  The pretax yield a taxable bond must attain for its yield to match a tax-exempt bond’s is its tax-equivalent yield. This measure compares the returns between a tax-free bond and a taxable alternative.
  

• SEC yield.

  A standardized calculation developed by the U.S. Securities and Exchange Commission, this provides a uniform and fair way to compare bond funds.
  

Other yield measures consider bonds that may be called, or redeemed early, or look at the worst possible yield a bond can achieve without defaulting.

Investing in bonds

The first thing investors will recognize about bonds is that there are several notable differences between investing in bonds versus investing in stocks. Generally speaking, bonds are more complicated to buy and sell than stocks.

• Traded by brokers.

  Unlike stocks, bonds aren’t offered to the public on an exchange. They’re generally traded over-the-counter between broker-dealers acting on their clients’ or their own behalf. These brokers serve as middlemen for interested investors.

• Don’t give holders an ownership stake.

  Instead, bondholders become creditors of the bond issuer. Stocks, in comparison, give investors equity in the company when they buy its shares. Stocks are known as equities, while bonds are referred to as fixed-income securities.

• Pricing is less uniform

  because fees and markups vary from brokerage to brokerage. U.S. Treasury bonds are an exception. They are available for purchase on the Treasury Directwebsite. To sell a bond before maturity, however, investors must transfer the bonds to a bank or brokerage.
  

Bond mutual funds and exchange-traded funds (ETFs) let investors buy and sell diverse pools of bonds in the same manner as stock funds. Bond funds are generally easier to invest in than individual bonds. Unlike single bonds, though, funds don’t have a set maturity, interest payments vary, and the investor’s income isn’t guaranteed.

Benefits and risks of investing in bonds

Bonds offer potential benefits and risks to investors.

Benefits

• Investors gain by locking in a regular source of income. They are guaranteed the money they’ve loaned will be repaid. And should the entity whose bonds they’ve bought default, bondholders take precedence over stockholders in a financial settlement or liquidation.
• Investors may add bonds to their portfolios to counterbalance the unpredictability of stocks. Bonds provide a predictable income stream and refund the original investment at maturity.
• Holders of government bonds enjoy tax advantages. Treasury securities are generally exempt from state and local taxes. Municipal bonds are generally not taxed at the federal level and can be free from state and local tax as well.

Risks

• They generally provide a lower return than stocks.
• Bonds are also affected by economic conditions. If interest rates rise, the bond’s price falls as investors seek higher yields. Inflation hurts an investor relying on a bond’s fixed interest payments.
• 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 or may fail to make the expected payments and default on its bonds.

The bottom line

Investors who understand what bonds are, how they work, and how to assess their risks and rewards are better prepared to wade into what can be unfamiliar and complex territory. At the most basic level, a bond is a loan or an IOU with specific terms and conditions. They tend to have lower total returns than stocks, but also less volatility and many investors use them in combination with equities to have a balanced investment portfolio.‍