Bonds: What They Are, How They Work & How to Invest

What Is a Bond?

A bond is a type of debt security. When an investor purchases a bond, the investor is generally lending money to the bond issuer.

The issuer could be the U.S. government, another government entity, a municipality, a corporation, or another organization.

In exchange for the loan, the issuer generally agrees to make interest payments and repay the bond's principal, also called face value or par value, according to the bond's terms.

The Securities and Exchange Commission's Investor.gov describes a bond as a debt security similar to an IOU. The key difference from stock is that a bond generally represents a loan rather than an ownership interest in a company.

How Do Bonds Work?

1. An issuer needs money. A government, municipality, company, or other issuer wants to borrow money for a particular purpose.
2. The issuer sells bonds. Investors purchase bonds and provide capital to the issuer.
3. The bond has defined terms. The bond can specify its face value, coupon rate, maturity date, payment schedule, and other provisions.
4. The issuer makes payments. Depending on the bond, investors may receive periodic interest payments.
5. The bond reaches maturity. If the issuer meets its obligations, the principal is generally repaid at maturity.

Important Bond Terms to Know

Face value

Face value is the principal amount that the issuer generally agrees to repay at maturity, subject to the bond's terms.

Coupon rate

The coupon rate is the stated annual interest rate applied to a bond's face value. For a conventional fixed-rate bond, the coupon generally remains the same throughout the bond's life.

Coupon payment

The coupon payment is the actual interest payment an investor receives. Many traditional bonds pay interest twice per year, although payment schedules vary.

Maturity date

Maturity is the date when the issuer is scheduled to repay the bond's principal.

Bond price

Bond price is what an investor pays to buy the bond in the market. The market price can be above or below the bond's face value.

Yield

Yield measures the income or return associated with a bond relative to its price and other characteristics. There are several types of yield calculations.

Credit rating

Credit ratings are assessments of an issuer's creditworthiness by independent rating organizations. Ratings are opinions about credit risk and are not guarantees that an issuer will make every payment.

Coupon Rate vs. Bond Yield

Coupon rate and yield are related but are not the same thing.

A bond's coupon is generally based on its face value. Yield takes the bond's market price into account.

For example, suppose a hypothetical bond has a $1,000 face value and pays $50 of annual interest. If the bond trades for $1,000, its simplified current yield is 5%.

If the same bond's market price falls to $900, the simplified current yield based on the $50 payment would be about 5.56%.

This simplified calculation does not capture every component of a bond's total return. Measures such as yield to maturity can account for additional factors.

Why Do Bond Prices Change?

Bonds can trade above or below their face value before maturity. Market interest rates are one of the most important factors affecting bond prices.

When market interest rates rise, existing fixed-rate bonds can become less attractive because newer bonds may offer higher rates. The price of existing bonds generally falls to make their yields more competitive.

When market interest rates decline, existing bonds with relatively higher coupon rates can become more attractive, which generally puts upward pressure on their market prices.

The relationship is not identical for every bond. Credit quality, maturity, liquidity, call features, supply and demand, and other factors can also affect prices.

What Is Bond Maturity?

Maturity refers to the amount of time until the bond's scheduled principal repayment date.

Bonds are often grouped into short-, intermediate-, and long-term maturities, although the exact definitions can differ by market source and product.

Maturity matters because bonds with longer maturities generally have greater sensitivity to changes in interest rates than otherwise similar shorter-maturity bonds.

Short-term bonds

Shorter-maturity securities generally have less interest-rate sensitivity than comparable longer-maturity securities.

Intermediate-term bonds

These sit between short- and long-term securities in maturity and interest-rate sensitivity.

Long-term bonds

Longer-maturity bonds can be more sensitive to changes in market interest rates.

What Is Bond Duration?

Duration is a measure used to estimate how sensitive a bond's price is to changes in interest rates.

Generally, a bond or bond portfolio with a higher duration will have greater price sensitivity to a given change in interest rates than one with a lower duration, all else being equal.

Duration is different from maturity. Maturity tells you when principal is scheduled to be repaid. Duration incorporates the timing and value of a bond's expected cash flows.

Types of Bonds

Bonds differ by issuer, maturity, credit quality, tax treatment, interest structure, and other characteristics.

U.S. Treasury securities

U.S. Treasury securities are debt obligations issued by the U.S. Department of the Treasury. Common categories include Treasury bills, Treasury notes, Treasury bonds, and Treasury Inflation-Protected Securities (TIPS).

Treasury securities are backed by the full faith and credit of the U.S. government. Their interest is generally subject to federal income tax but exempt from state and local income taxes.

Corporate bonds

Corporate bonds are issued by companies to raise money. The issuer agrees to make payments according to the bond's terms.

Corporate bonds can have different credit ratings. Investment-grade bonds generally have higher credit ratings than non-investment-grade or high-yield bonds.

Municipal bonds

Municipal bonds are issued by states, cities, counties, and other governmental entities to finance public projects or other purposes.

Interest from many municipal bonds is generally exempt from federal income tax, although the exact tax treatment depends on the bond and investor's circumstances.

Savings bonds

U.S. savings bonds are Treasury securities designed for individual investors. Series EE and Series I savings bonds have different interest structures and redemption rules.

TIPS

Treasury Inflation-Protected Securities are designed with principal adjustments linked to changes in the Consumer Price Index. Their interest payments can change because the principal amount changes.

U.S. Treasury Bills, Notes and Bonds

U.S. Treasury securities have different maturities.

Treasury bills are different from traditional coupon-paying bonds. They are generally issued at a discount and mature at face value, with the difference representing the investor's interest.

What Are Series I Savings Bonds?

Series I savings bonds are U.S. savings bonds whose interest rate combines a fixed component with an inflation component that is adjusted periodically.

Unlike a traditional fixed-rate bond, an I Bond's interest structure is designed to respond to inflation changes.

I Bonds also have specific purchase, holding-period, and redemption rules. Investors should review the current TreasuryDirect rules before purchasing because limits and procedures can change.

Corporate Bonds

Companies issue corporate bonds to borrow money. Investors generally receive interest payments and the return of principal according to the bond's terms.

Corporate bonds carry credit risk because the company could experience financial difficulties and fail to make required payments.

Credit ratings can help investors evaluate relative credit risk, but a credit rating is not a guarantee that the issuer will repay the bond.

High-yield corporate bonds generally have lower credit ratings and therefore carry greater credit risk than investment-grade bonds. Higher yields can accompany that additional risk.

Municipal Bonds

Municipal bonds, often called "munis," are issued by states, municipalities, counties, and other governmental entities.

Municipal bonds can finance projects such as infrastructure, schools, hospitals, transportation systems, and other public activities.

The tax treatment of municipal bond interest can be an important consideration. Interest from many municipal bonds is generally exempt from federal income tax, but exceptions and additional tax considerations can apply.

Individual Bonds vs. Bond Funds

Investors can buy individual bonds or gain exposure through bond mutual funds and bond ETFs.

A bond fund does not promise to return your original investment at a specific maturity date. Its value can fluctuate as the underlying bonds change in value.

Risks of Investing in Bonds

Bonds can be less volatile than some stocks in certain circumstances, but they are not risk-free.

Interest-rate risk

Rising interest rates generally reduce the market value of existing fixed-rate bonds. The effect can be larger for bonds with longer durations.

Credit or default risk

An issuer may be unable to make scheduled interest or principal payments.

Inflation risk

Inflation can reduce the purchasing power of fixed interest payments and principal.

Liquidity risk

Some bonds trade less frequently than others. An investor may have difficulty finding a buyer at a desired price.

Call risk

Some bonds allow the issuer to repay the bond before its scheduled maturity. If a bond is called when interest rates are lower, the investor may need to reinvest at a lower rate.

Reinvestment risk

Interest payments and principal received from a bond may need to be reinvested at lower rates than the original investment.

Market risk

If an investor sells a bond before maturity, its market price may be above or below the amount originally paid.

What Happens If You Hold a Bond Until Maturity?

If an investor holds a bond until maturity and the issuer fulfills its obligations, the investor generally receives the bond's face value at maturity along with the scheduled interest payments.

This does not mean that holding a bond to maturity eliminates every risk. Credit risk, inflation risk, reinvestment risk, and opportunity costs can still matter.

Also, if an investor sells before maturity, the bond's market price may be different from its face value.

How Are Bonds Taxed?

Bond taxation depends on the type of bond, the account in which it is held, the investor's circumstances, and the applicable tax rules.

U.S. Treasury securities

Interest from U.S. Treasury securities is generally subject to federal income tax but exempt from state and local income taxes.

Municipal bonds

Interest from many municipal bonds is generally exempt from federal income tax. State and local treatment can depend on the bond and the investor's residence.

Corporate bonds

Interest from corporate bonds is generally taxable in a taxable account.

Bond sales

Selling a bond for more or less than your adjusted tax basis can create a capital gain or loss, depending on the circumstances.

What Is a Bond Ladder?

A bond ladder is a strategy that spreads investments across bonds with different maturity dates.

For example, an investor could own bonds maturing in different years instead of putting the entire bond allocation into one maturity.

As individual bonds mature, the investor can use the returned principal or reinvest it according to their objectives.

Bond ladders can involve trade-offs involving interest rates, liquidity, reinvestment risk, taxes, and transaction costs.

What Is a Bond Yield Curve?

A yield curve shows the relationship between yields and maturities for bonds or other debt securities with similar characteristics.

A commonly referenced yield curve compares Treasury yields across different maturities.

The shape of the curve can change over time as investors' expectations for inflation, economic growth, monetary policy, and interest rates change.

How to Buy Bonds

1. Define the purpose. Determine whether the investment is intended for income, diversification, a future spending need, or another objective.
2. Choose the type of bond. Consider Treasuries, municipal bonds, corporate bonds, savings bonds, or other fixed-income securities.
3. Review maturity. Understand when principal is scheduled to be repaid.
4. Review credit quality. Consider the issuer's financial strength and available credit information.
5. Compare yield and price. Understand how the bond's current market price affects its yield.
6. Review call provisions. Determine whether the issuer can repay the bond before maturity.
7. Check tax treatment. Understand how interest and potential gains or losses may be taxed in your account.
8. Understand transaction costs. Review commissions, markups, markdowns, spreads, and other applicable costs.

How to Research a Bond

FINRA recommends considering characteristics such as maturity, security provisions, yield, call status, tax treatment, and credit rating when evaluating bonds.

• Identify the issuer.
• Check the bond's maturity date.
• Review the coupon rate.
• Review the current yield and other relevant yield measures.
• Check the credit rating where available.
• Review call provisions.
• Understand whether the bond is secured or unsecured.
• Review the bond's tax treatment.
• Consider liquidity and trading costs.
• Review the issuer's financial information.

Bonds vs. Stocks

Bonds and stocks represent fundamentally different types of investments.

Why Do Investors Use Bonds?

Investors may use bonds for several different purposes.

• Generating interest income.
• Diversifying across asset classes.
• Matching investments with future spending needs.
• Reducing exposure to equity-market movements within a broader portfolio.
• Preserving capital in certain lower-risk bond categories, subject to issuer and market risks.

The role of bonds can vary substantially depending on the investor's time horizon, financial goals, other assets, and risk tolerance.

Common Bond Investing Mistakes

• Looking only at a bond's coupon rate.
• Ignoring the bond's current market price.
• Confusing coupon rate with yield.
• Ignoring interest-rate risk.
• Assuming every government-related bond has identical risk.
• Ignoring credit quality for corporate or municipal bonds.
• Overlooking call provisions.
• Forgetting about inflation risk.
• Ignoring liquidity and transaction costs.
• Treating bond funds as identical to individual bonds.
• Assuming a bond investment is guaranteed simply because it pays regular interest.

Bond Investing Checklist

• Know who issued the bond.
• Understand the bond's maturity.
• Review the coupon rate.
• Check the current price.
• Understand the yield.
• Review credit quality.
• Check for call provisions.
• Consider interest-rate sensitivity.
• Consider inflation risk.
• Review liquidity.
• Understand applicable taxes.
• Review transaction costs.

Frequently Asked Questions About Bonds

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Investment Disclaimer

The information on this page is for general educational purposes only and is not investment, tax, or financial advice. Bonds involve risk, including the possible loss of principal. Individual bonds, bond funds, Treasury securities, municipal bonds, and corporate bonds can have substantially different risks and tax characteristics.

Before investing, review the applicable offering documents, prospectus, bond terms, credit information, fees, tax treatment, and other official information. Consider your own financial situation, goals, time horizon, and risk tolerance.