Bonds: What Are They And How Do They Work?
Lauren Nowacki6-Minute Read
December 01, 2021
When it comes to building an investment portfolio, diversification is important. Having different types of investments helps balance your portfolio and manage risk. One investment to add to the mix is bonds.
What Is A Bond?
A bond is an investment product formed when an investor (the bondholder) gives money to a company or other entity (the bond issuer) for a set amount of time while the issuer makes regular interest payments on the loan. The bond issuer then returns the investor’s money once the bond reaches maturity.
How Do Bonds Work?
When a company or other entity wishes to borrow money from investors, it issues bonds to those who purchase them. These bonds act like an IOU from the borrowing entity (bond issuer) to the investor (bondholder). The bond will last a certain amount of time, during which the bondholder receives interest payments on the bond. These payments last until the maturity date, when the amount borrowed is paid back in full.
There are short-, medium- and long-term maturity dates, lasting anywhere from 1 – 3 years to more than 10 years. The amount of interest paid during the life of the bond is the bondholder’s return on investment.
Bonds can be sold and traded. If the bondholder sells or trades the bond for more than they paid on it, they’ll make a profit. If they sell it before the maturity date for less than they paid, they’ll lose money.
Characteristics Of Investment Bonds
To better understand bonds, it’s important to know a few of the characteristics that define them. Here are a few key terms to know.
- Maturity: The life of the bond. When it hits its maturity date, the bond issuer pays back the bond in full.
- Rating: The creditworthiness of the bond issuer. The rating will tell the investor how risky the bond is and how likely the bond issuer may default on its payment. The lower the rating, the higher the risk.
- Face value: The original price of the bond when it’s first issued before its price fluctuates with the market. This is the amount that is paid back when the bond hits maturity.
- Coupon: The fixed interest rate the bond issuer pays to the bondholder until the bond’s maturity date.
- Yield: How much return on investment you’ll get from the bond. The yield is calculated by dividing the coupon, or interest rate, by its face value.
- Duration risk: The bond’s sensitivity to rate changes. Bond prices are affected by interest rates. Oftentimes, the longer the bond’s term, the greater the risk of the bond’s price changing as interest rates change.
Types Of Bonds
Bonds can be categorized into four main types, including:
- Government bonds: These bonds are issued by federal governments, both U.S. and foreign governments. The U.S. Treasury Department issues Treasury bonds that fund day-to-day operations and government projects, including infrastructure. Government bonds are exempt from state and local income taxes, but not federal.
- Municipal bonds: These bonds are issued by state and local governments to fund community projects, like improving roads and local school systems. These types of bonds are exempt from federal taxes and can also be exempt from many state and local taxes. These bonds are also known as “muni bonds.”
- Corporate bonds: These bonds are issued by corporations. The bond is often used to raise capital for the company. This additional money can help fund day-to-day operations, help the company expand, fund acquisitions or finance a new project. These types of bonds are riskier than government bonds and, because of this, often have a higher interest rate. Corporate bonds are not exempt from state or federal income taxes.
- Agency bonds: These bonds are issued by government agencies and government-sponsored enterprises (GSEs) like Fannie Mae and Freddie Mac. Agency bonds help fund things like mortgages, home buying education and agricultural assistance. These bonds may be exempt from some state and local taxes, but not federal taxes.
Bonds can also be classified according to other features, primarily the way interest is paid.
- Zero-coupon bonds: These bonds do not have interest payments (coupons). Investors make money from them by purchasing them below their face value. At maturity, the bond issuer repays the bond at its face value.
- Convertible bonds: These are corporate bonds that can be turned into the corporation’s shares of stock before hitting the maturity date.
- Callable bonds: Before issuing these types of bonds, the bond issuer and holder can agree to certain conditions that allow the issuer to pay the bond back in full before the maturity date. This is also known as “calling the bond” before maturity.
- Puttable bonds: These bonds have certain options for bondholders to get early repayment of the bond at specified dates before it reaches the maturity date.
Pros Of Buying Bonds
Along with helping diversify your portfolio, bonds can help lower some of the risks of investing by balancing against more unpredictable investments, like stocks. Bonds are seen as lower-risk investments and provide a form of fixed income. The bond issuer is paying a fixed interest throughout the life of the bond, which the bondholder receives as fixed payments until the maturity date.
There can also be an emotional benefit to buying bonds as well. Depending on the type of stock the investor buys, they can feel good knowing that their money is helping fund a community project, improve a local school or help a company grow.
Cons Of Buying Bonds
While bonds do have a lower risk than other investments, they do still carry some risk. There is always the risk that the bond issuer can default on their payments and the bondholder loses the amount of money they loaned.
The lower risk that comes with bonds can also be a disadvantage because it provides a smaller return than an investor may get in something a little riskier, like stocks. When it comes to investing, it’s often true that the greater the risk, the greater the reward.
How Are Bonds Priced?
There are two types of bond pricing. The first is the original, face value price – also known as par. This is the amount the bond issuer wishes to borrow and what will be paid back when the bond reaches its maturity date.
The second price is when the bond is sold in the secondary market. Bonds can be sold above or below their face value in the secondary market. Those sold above face value are sold at a premium to par and those sold below their face value are sold at a discount to par.
Several factors impact a bond’s price in the secondary market. These include:
- Supply and demand
- The bond’s term to maturity
- The bond issuer’s rating
- Current market interest rates
Here’s an example of how interest rates can affect pricing.
If an investor has a bond they’re looking to sell and interest rates increase, the bond’s value drops because the interest rate that the bond is getting paid on is now lower than the current rate. Conversely, if interest rates go down, the bond’s value increases because the interest payment on the bond is higher than the current interest rate.
How To Invest
Aside from treasury bonds, which you can buy directly from the U.S. government, you’ll need to use a broker because bonds aren’t publicly traded.
There are a few ways to invest in bonds:
- You can buy bonds when they are first issued, at their face value.
- You can buy bonds on the secondary market when they may be sold higher or lower than their face value.
- You can buy a mix of different bonds through a mutual fund.
- You can buy a mix of different bonds through a bond exchange-traded fund (ETF).
When choosing the right option for your financial goals, it’s recommended you speak to a financial advisor or investment professional.
The Bottom Line
A bond is a type of investment that works as a loan to a corporation or other entity. The investor loans the money by purchasing the bond and receives interest payments until the bond is repaid in full on its maturity date. The investor can choose to sell the bond before its maturity date, either above or below its face value.
Bonds are a relatively low-risk investment, but you should speak with a financial advisor for more information. Check out our other articles on personal finance to learn more about other saving and investment options you may have.
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