What Is a Bond? How Do Bonds Work?

Written by Kim PinnelliReviewed by Nathan Brown, CFP®Updated: 19th Apr 2022
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A bond is a loan only this time, it’s you making the loan, not a company. They can be a great investment for certain investors and belong in just about every portfolio.

Here’s what you need to know about bonds, how they work, and key metrics.

What is a Bond?

A bond is a loan to a corporation or the government. In other words, you are the lender – lending money to big companies or the federal/state government. In exchange for the loan, you earn interest that you receive periodically throughout the bond’s life. At maturity, you’ll receive your investment back.

How Do Bonds Work?

Bonds are simple to understand and invest in, making them great for beginning investors. An organization issues a bond with a specific maturity date and specified amount. If you invest in it, you pay the bond’s face value – giving the organization the money in exchange for the bond.

You are now the creditor or debtholder. In the specified intervals, you’ll receive interest payments.

Here’s an example:

You buy a bond for $1,000 from Company XYZ. The company promises to pay you 4% interest on the bond semi-annually. The bond has a maturity date of 3 years.

You earn $40 interest per year, but you make $20 every six months since it pays semi-annually. At the end of the 36th month, Company XYZ pays you back the $1,000, and you walk away with $1,120 total.

As the debtholder, you can decide to keep the bond until maturity or sell it on the secondary market beforehand.

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Different Types of Bonds

#1. Government Bonds (U.S. Treasury)

Government or treasury bonds are among the safest bonds to invest in. While they don’t have a high return rate because of their low risk, it’s nice to have a stable investment in your portfolio. When you buy government bonds, you lend the government money to cover expenses that taxes don’t cover.

#2. Municipal Bonds

Money loaned to state or local governments makes up municipal bonds. Government agencies use these funds to cover large projects to improve the state or city, including new roads and funding new schools.

#3. Corporate Bonds

Corporate bonds are from companies looking for funding that don’t want traditional bank funding. Bonds are less expensive for corporations but riskier for the creditors because there isn’t a government guarantee.

#4. Agency Specific Bonds

Agency-specific bonds are issued by the government affiliate departments. They aren’t as low risk as treasury bonds, as many agency-specific bonds don’t have a guarantee.

Types of Bonds

  • Zero-Coupon Bonds: Zero-coupon bonds sell at a discount and pay the creditor the full-face value at maturity rather than receiving interest payments throughout the bond’s term. You earn the same amount, but you receive the entire amount at maturity rather than having a steady cash flow.
  • Convertible Bonds: Convertible bonds sell at a lower interest rate but give the bondholder the option to convert the bond to stock ownership during its term. The converting is dependent on the stock price – once the stock is worth more than the stated value, bondholders may convert.
  • Callable Bonds: As the name suggests, a corporation can ‘call back’ an issued bond before maturity. Companies do this for various reasons, but typically if they can save money by getting a lower interest rate because they need to borrow less money or their credit rating improves. Callable bonds are risky for creditors because companies can call the bond back at any point, but they usually do it when bond rates rise.
  • Puttable Bonds: Callable bonds give the company the option to turn a bond in early, but a puttable bond allows the creditor to ‘give it back.’ If bond rates fall, or you want your money back because you’re worried about them falling, you can call a bond back (turn it in early). Puttable bonds trade at higher values because they provide bondholders with more benefits.

Bond Terminology, Definitions, and Traits to Know

  • Face Value: The amount the bond is worth at maturity or the amount the company or government pays you back. This is also the amount used to calculate the bond’s interest payments.
  • Market Value: The price you can sell the bond to another investor. This is before the bond reaches its maturity. 
  • Issue Price: This is the price you pay for the bond; it may be sold at a premium or discount depending on the market.
  • Coupon Date: These are the dates you can expect interest payments. Most bonds pay semi-annually.
  • Maturity Date: This is the date you’ll receive the full payment (principal balance) back.
  • Coupon Rate: This is the interest rate you’ll earn. It’s written as a percentage and is calculated as a percentage of the bond amount.

What Are the Advantages of Bonds?

  • Reliable Fixed-Income: You can rely on the interest payments as long as you hold the bond. You’ll know the intervals in which you’ll receive the interest when you buy the loan.
  • Relatively Safe Investment: Bonds are typically safe investments unless the company goes under. Government bonds have the highest level of security as they rarely default.
  • Resell Profit Potential: If the market works in your favor, you may be able to sell the bonds on the secondary market for a value higher than you paid.
  • Favor Long-Term Investors: If you’re a set-it-and-forget-it type investor, you’ll benefit from bonds because you invest the money and then let it sit until maturity. You get a set rate of return which you know when you invest.

What Are the Disadvantages and Risks of Bonds? 

  • ROI Can Be Low: Because of the low risk, the rate of return is often low. It’s the tradeoff for the lower risk level.
  • Interest Rate Fluctuations: Bond rates fall when interest rates rise and vice versa. Like the stock market, no one can predict it. This could hurt the bond value.

How Are Bonds Rated?

A bond rating shows the creditworthiness of the bond. Bond ratings are displayed in letters from AAA to D, with AAA being the highest rating.

Moody Investors Service, Fitch Ratings, and Standard & Poor’s rate bonds and have their own rating model. A bond’s grade determines the company’s financial strength and the likelihood that it will repay it.

Common Risks Investing in Bonds

  • Credit Risks: You take a risk that the issuer won’t make good on its bond and will default. This means you don’t get your money back or earn interest.
  • Inflation Risk: If inflation increases rates beyond your interest rate, you could decrease your purchase power and rate of return.
  • Liquidity Risk: While you can sell some bonds on the secondary market, they aren’t as liquid as stocks meaning you can’t sell them anytime you want.
  • Call Risk: Companies can call the bond back, aka pay you off. They often do this when interest rates fall, and they can get the money at a cheaper rate. Think of it like you are refinancing your mortgage at a lower rate.
  • Reinvestment Risk: If you can’t reinvest the money you earn (interest) at the same interest rate, it’s a reinvestment risk. In other words, you can get the same rate of return because rates fall. This is most common with short-term bonds.

Relationship Between Bonds and Interest Rates

Bonds and interest rates have an inverse relationship. When interest rates rise, bond values fall, and vice versa.

Example

If the interest rate is expected to increase for any reason (including, but not limited to, expected increases in inflation), bond prices are expected to fall, so the demand will decrease. Investors want out because of the higher rate of return on other investments. When interest rates fall, demand for bonds increases because bond interest rates are fixed, making them more attractive in a falling economy.

Who Should Invest in Bonds?

Bonds are a great investment for risk-averse borrowers. If you can’t stand the thought of losing money, the conservative nature of bonds will keep your mind at ease. Even if you aren’t risk-averse and invest in stocks, diversifying your portfolio with a few conservative investments is a good idea. When stocks do poorly, bonds may do well, offsetting your losses. However, it is important to note that bonds fluctuate in value regularly due to changes in interest rates and inflation. While most financial advisors agree that bonds are a safer asset class, they still carry a degree of risk that you need to account for. 

Finally, if you’re nearing your goal, such as retirement, choosing bond investments is better since your risk tolerance decreases the closer you get to your goal’s timeline.

What is the Average Rate of Return for Bonds?

On average, government bonds give a 5 – 6% rate of return. Compare that to the stock market’s average 10% return over ten years, and bonds don’t seem like the best investment, but they can offset the riskiness stocks pose.

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Bonds FAQs

Are Bonds Considered a Safe Investment?

Overall, bonds are safe. They have less volatility than stocks, but they do vary in value. You can lose money – so don’t assume they are 100% foolproof.

Are Corporate Bonds Risky?

Corporate bonds are riskier than government bonds, but you also get a higher rate of return to make up for the risk. A diversified bond portfolio will include corporate, municipal, and federal government bonds. This diversification will reduce risk further, and will protect you when interest rates and inflation metrics change. 

Why Are Bonds Better for People Nearing Retirement?

Because bonds are less likely to lose money, they are a good, stable investment for those nearing retirement. The last thing you need is to lose your entire retirement savings because of a risky investment right before retirement.

Bottom Line: What Is a Bond?

Investing in bonds means you lend the government or company money. While there is some risk, they are a conservative investment that helps offset other risky investments in your portfolio.

A bond provides a fixed cash flow and has a predetermined term, so you know when you’ll get your money back.

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Kim Pinnelli
Kim Pinnelli

Kim Pinnelli is a Senior Writer, Editor, & Product Analyst with a Bachelor’s Degree in Finance from the University of Illinois at Chicago. She has been a professional financial writer for over 15 years, and has appeared in a myriad of industry leading financial media outlets. Leveraging her personal experience, Kim is committed to helping people take charge of their personal finances and make simple financial decisions.