What is a bond?
October 11, 2022 7 min read
Bonds are a type of debt that businesses and governments use to finance projects or pay off other obligations. They’re like loans that are repaid over time with interest.
There are many types of bonds that can match different needs of investors. Read on to learn more about what bonds are, how they work and how they differ from other investment options.
- A bond is one way for corporations and governments to generate money for projects, as bonds act like loans.
- Bonds pay bondholders dividends until they reach their maturity date, when the initial investment is repaid.
- Examples of bonds include corporate bonds, municipal bonds and U.S. Treasury bonds.
- Bonds are less volatile investments than stocks or mutual funds but have a lower maximum yield.
Bond terms to know
If you’re just getting started in investing, here are a few terms to know as you decide whether bonds are right for your portfolio:
- Face value: Also known as par value, the face value is what the bond is initially worth.
- Price: The price of a bond is what you pay to own the bond. It may be the face value, but it may also be more—a premium—or less—a discount—than the face value if you’re buying it on a secondary market.
- Maturity: Maturity is the length of time before the bond must be repaid by the borrower.
- Coupon rate: The coupon rate is the interest rate on the bond.
- Coupon payment: The coupon payment is the borrower’s interest payment to a bondholder.
- Yield to maturity: The yield to maturity calculates how much return a bondholder will get for a bond over the course of a year. It factors in when you bought the bond and what you paid for it.
How do bonds work?
In simple terms, a bond is like an IOU that organizations take out to pay for projects. Corporations and the federal government are the most common issuers of bonds. Municipalities, such as states and cities, may also issue bonds.
Like a loan, a bond has an interest rate—or coupon rate—and a time when it must be repaid. A bondholder gets interest payments—or coupon payments—at regular intervals throughout the term of the loan. At the end of the term—known as the maturity date—the issuer must repay the money a bondholder lent them. Depending on the type of bond, the maturity date may be less than three years or up to 30 years.
Borrowers that fail to repay borrowed money at the maturity date risk having their creditworthiness downgraded. A bond issuer that defaults on its bond may find that it must offer a higher interest rate in the future to attract new investments.
Examples of bonds
Corporations, municipal governments and the U.S. government issue bonds. Each of these issuers offers different types of bonds to meet their funding needs.
Corporate bonds are issued by corporations. Unlike stocks, these may be offered by both public and private corporations, as they don’t confer ownership in the company. Corporate bonds can be used to:
- Refinance corporate debt.
- Invest in research and development.
- Pay shareholder dividends.
- Lease or purchase new equipment or locations.
- Finance mergers and acquisitions.
Corporate bonds may be discussed in two ways:
- Maturity: The maturity date of a corporate bond may be long term (10+ years), medium term (four to 10 years) or short term (fewer than three years).
- Creditworthiness: This is how risky the investment is for a particular company. A company’s bonds may be investment grade, with less risk but a lower interest rate. Or the bonds might be non-investment grade, with more risk but a higher interest rate to motivate buyers.
Corporate bonds may have fixed or floating interest rates. A fixed rate means that coupon payments will stay the same throughout the term. On the other hand, a floating interest rate can be reset at certain periods. Some corporate bonds—called zero-coupon bonds—don’t make any coupon payments until the bond has matured. In this case, the future interest to be paid is set when the investor purchases the bond.
Municipal bonds are issued by state, county or city governments to supplement or replace taxpayer money for projects—like building schools or highways—or other obligations. They often come with tax benefits, particularly if the bondholder lives in the municipality’s state. As they tend to be safer than high-yield corporate bonds, municipal bonds typically have low interest rates.
The two main types of government bonds are general obligation bonds and revenue bonds. General obligation bonds are not backed by other assets, as the municipality has the power to get the funds to repay investors through taxes. Revenue bonds are repaid through the revenue generated by the target project.
U.S. Treasury bonds
The federal government offers long-term bonds as an option for investors. U.S. Treasury bonds come with terms of either 20 or 30 years. Bondholders are paid interest every six months and then have the face value of the bond repaid on its maturity date. Investors can sell their bonds after meeting the minimum ownership requirements of 45 days.
The interest payments from U.S. Treasury bonds are exempt from state and local taxes but not usually federal income tax.
How do bonds compare to other investments?
If you’re dipping your toes into investing, bonds are likely one of many investment options you’ve heard about. Below, we’ll consider how bonds compare to other investments.
Bonds vs. stocks
A stock is an investment in a company. Unlike bonds, when you purchase a stock, you own a fraction of the ownership of the company.
However, stocks typically have greater risk than bonds. You have the potential to earn a larger return on your investment with a stock compared to a bond. But you might also face a greater chance of losing money on your investment with stocks compared to bonds.
Bonds vs. mutual funds
Mutual funds are investments into a pool of resources that may include stocks, bonds and other debt securities. Mutual funds may either be managed by a professional or unmanaged.
Because of their diversified nature, mutual funds tend to be less risky than stocks while still keeping a chance for big gains. But unless the mutual fund is made up solely of bonds, it can be riskier than investing in bonds alone. Mutual funds can also incur fees and other expenses that negatively impact the value of the investment.
Are bonds a good investment?
When deciding whether bonds are right for you, it’s important to know their benefits and risks.
Benefits of investing in bonds
The biggest benefit of bonds is that they have more stable returns on investments than many other options. This can help you plan for retirement.
Depending on the type of bond, coupon payments may also be exempt from state or local taxes.
Risks of investing in bonds
While bonds are more secure than other investments, they still come with risks. These include:
- Defaulting: Borrowers may fail to make coupon payments or even return the principal on the maturity date.
- Interest rate changes: Because of the longer-term nature of bonds, they are less affected by changes in interest rates. But if the market changes substantially, you may be holding bonds with substantially lower interest rates than the market average. You may have trouble selling the bonds at face value if you want to invest in new bonds with higher interest rates.
- Liquidity: The trouble you may face trying to sell a bond is known as liquidity risk. That means it’s harder for you to turn a bond back into money that you can spend elsewhere.
- Calls: A borrower may opt to make a call on the bond, retiring it before its maturity date. While you will get paid for the face value of the bond, you lose out on any remaining coupon payments.
Bonds in a nutshell
Bonds are investments with relatively low interest rates because they are more secure than other debt securities. They can be backed by assets or assurances by the bond issuer. Bondholders may have to wait decades to see the return of their initial investment, but they’ll receive regular payments throughout the term of the bond.