What Are Bonds? How They Work and How to Invest

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A bond is a debt security: the investor lends money to a government, agency, municipality or company, and the issuer promises to pay interest on a set schedule and return the loan’s face value on a set date. The issuer receives the money; the bondholder becomes a creditor, not an owner. Bonds are called fixed-income securities because many pay a predetermined interest rate. Along with stocks and cash equivalents, they are one of the main asset classes individual investors hold.

How Bonds Work

An organization that needs money can borrow from a bank or issue bonds to investors. Governments use bonds to fund roads, schools, dams and other public projects and to cover budget gaps; companies use them to expand, buy property and equipment, fund research or hire staff, often on more favorable terms than bank loans.

The issuer sets the terms at sale: the amount borrowed per bond, the interest rate, the payment dates and the date the principal is repaid.

Bonds do not have to be held until maturity. After issue they trade among investors in the secondary market, and the issuer pays interest to whoever holds the bond on each payment date.

Core terms

• Face value (par value): the amount repaid at maturity and the base for calculating interest. Many bonds have a face value of $1,000.
• Coupon rate: the annual interest rate the issuer pays on face value. A $1,000 bond with a 5% coupon pays $50 a year, often split into two $25 semiannual payments.
• Coupon dates: the scheduled dates on which interest is paid.
• Maturity date: the date the issuer must repay face value. Missing that payment, or a coupon payment, is a default.
• Issue price: the price at which the bond is first sold. Many bonds are issued at or near par.
• Market price: what the bond trades for after issue. It depends on the issuer’s credit quality, the time left to maturity, and how the coupon compares with current interest rates.

Market prices are often quoted as a percentage of par. A quote of 98 on a $1,000 bond means $980.

Types of Bonds

Bonds fall into four main categories by issuer. Some platforms also offer foreign bonds issued by overseas governments and corporations.

• Treasuries: debt issued by the U.S. Treasury. Bills have maturities of one year or less, notes run up to 10 years, and bonds run longer than 10 years. Treasury Inflation-Protected Securities (TIPS) adjust their principal with inflation as measured by the Consumer Price Index.
• Agency bonds: issued by government-affiliated organizations such as Fannie Mae and Freddie Mac.
• Municipal bonds: issued by states, cities and other local authorities. Interest on some municipal bonds is exempt from federal income tax, and in some cases from state and local tax for residents of the issuing state.
• Corporate bonds: issued by companies. They usually pay more than government debt of similar maturity because the investor takes on the company’s credit risk.

Bond variations

• Zero-coupon bonds pay no periodic interest. They are sold below face value and return the full face value at maturity. Treasury bills work this way.
• Floating-rate bonds reset their coupon periodically based on a reference rate.
• Convertible bonds let the holder exchange the bond for a set number of the issuer’s shares under specified conditions, such as the share price reaching a level.
• Callable bonds let the issuer repay early, typically when rates have fallen and it can refinance more cheaply, just when the bond has gained value. To compensate buyers, they usually carry higher coupons.
• Puttable bonds let the holder sell the bond back to the issuer before maturity, protecting against rising rates or a weaker issuer outlook, so they typically trade at a higher price than otherwise identical bonds without the put.

Why Bond Prices Move Opposite to Interest Rates

A fixed-rate bond’s coupon never changes, but the market’s required return does. When new bonds pay more, nobody will pay full price for an older, lower-paying bond, so its price drops until its return matches theirs. When rates fall, its higher coupon becomes more valuable and buyers bid the price up.

A bond’s price equals the present value of all its remaining payments, discounted at the current market rate:

Price = C / (1 + r)¹ + C / (1 + r)² + … + (C + F) / (1 + r)ⁿ

where C is the coupon payment per period, F is face value, r is the market rate per period and n is the number of periods left.

Worked example

Hypothetical: a bond has a $1,000 face value, a 5% annual coupon ($50 a year) and two years left to maturity. Assume one coupon per year.

• Market rate stays at 5%: the price is $1,000. The bond pays exactly what the market requires.
• Market rate rises to 6%: price = $50 / 1.06 + $1,050 / 1.06² = $47.17 + $934.50 = $981.67. The bond trades at a discount.
• Market rate falls to 4%: price = $50 / 1.04 + $1,050 / 1.04² = $48.08 + $970.78 = $1,018.86. The bond trades at a premium.

Two points follow from this. First, an investor who holds the bond to maturity still collects $50 a year and $1,000 at the end, whatever happens to its market price in between; the price change only becomes a realized gain or loss if the bond is sold. Second, as maturity approaches, a bond’s price drifts toward face value, because fewer payments remain to be revalued.

Measuring Return: Coupon, Current Yield and YTM

The coupon rate alone does not tell you what you will earn, because you may pay more or less than face value.

Current yield is the annual coupon divided by the current price. In the example above, the bond priced at $981.67 has a current yield of $50 / $981.67, about 5.09%. Current yield ignores the gain or loss from price converging to par at maturity.

Yield to maturity (YTM) captures that. It is the discount rate that makes the present value of all remaining coupons and the face value equal the bond’s current price, in other words its internal rate of return. YTM assumes the bond is held to maturity, every payment arrives on schedule and coupons are reinvested at the same rate. In the example, buying at $981.67 produces a YTM of 6%, the rate used to price it. Expressed as an annual rate, YTM is the standard way to compare bonds with different coupons and maturities. It is found by trial and error or with a calculator, as the yield to maturity guide shows.

For callable bonds, investors also look at yield to call, which assumes the issuer redeems the bond at the earliest call date.

What Determines a Bond’s Coupon Rate

When a bond is issued, its coupon is set mainly by two factors:

• Credit quality. An issuer more likely to default must pay more interest to attract lenders. A highly rated government can borrow more cheaply than a heavily indebted company.
• Time to maturity. Longer bonds usually pay higher rates because the lender is exposed to interest rate changes and inflation for longer. The relationship between yields and maturities across the market is shown by the yield curve.

The general level of interest rates at the time of issue sets the baseline that both factors are added to.

Credit ratings

Credit rating agencies, chiefly S&P Global Ratings, Moody’s and Fitch Ratings, assess the likelihood that an issuer will pay interest and principal in full and on time. Bonds rated BBB- or higher by S&P and Fitch, or Baa3 or higher by Moody’s, are considered investment grade. Debt from the U.S. government and financially stable companies typically falls in this group.

Bonds rated below that level but not in default are called high-yield or junk bonds. They carry a higher risk of future default, so investors demand higher coupons. A rating is the agency’s opinion at a point in time and can be downgraded, which usually pushes the bond’s price down.

Duration: How Sensitive a Bond Is to Rates

Duration measures how much a bond’s price changes when interest rates change. Despite the name, it is not the time left until maturity, though the two are related. The commonly used version, modified duration, gives the approximate percentage price change for a one percentage point change in yield:

% price change ≈ −modified duration × change in yield

Hypothetical: a bond with a modified duration of 7 would fall about 7% in price if its yield rose by one percentage point, and gain about 7% if its yield fell by one point. The estimate is a straight-line approximation; for large rate moves, a refinement called convexity improves it.

Bonds with longer maturities and lower coupons have higher duration, so they react more strongly to rate changes. A zero-coupon bond’s duration equals its maturity, because all its value arrives in one final payment. Short-term, high-coupon bonds have the least rate sensitivity.

How to Invest in Bonds

1. Through a brokerage account. Many online and discount brokers offer Treasuries, municipal and corporate bonds, at issue or in the secondary market. Most bonds trade over the counter rather than on an exchange, and the price includes a dealer markup or markdown, so comparing quotes matters more than with listed shares.
2. Directly from the government. U.S. Treasury bills, notes, bonds and TIPS can be bought at auction through the government’s TreasuryDirect website without a broker.
3. Through funds. Bond mutual funds and exchange-traded funds hold portfolios of many bonds, giving diversification across issuers and maturities with a smaller investment. Their value per share is tracked by net asset value.

Individual bonds vs. bond funds

An individual bond has a maturity date: if the issuer pays as promised, you get face value back on that date regardless of rate moves. A bond fund keeps buying and selling bonds to maintain its target maturity, so it has no maturity date, no promised return of principal and a share price that moves with rates indefinitely. Funds offer diversification, professional management and easy trading but charge ongoing expense ratios; individual bonds give a defined endpoint but concentrate credit risk unless you buy many issues.

Limitations and Risks of Bonds

Bonds are often described as safer than stocks, but they carry their own risks:

• Interest rate risk: rising rates reduce the market value of existing bonds, most for long-duration bonds and anyone who must sell before maturity.
• Credit and default risk: the issuer may miss interest or principal payments. Treasuries are backed by the full faith and credit of the U.S. government; corporate and municipal issuers carry varying levels of risk.
• Inflation risk: fixed payments buy less as prices rise. A bond yielding 4% earns little in real terms if inflation runs near that level, as historical U.S. inflation rates illustrate. TIPS are designed to address this.
• Reinvestment risk: when coupons are received or a bond matures, rates may be lower, so the money earns less going forward.
• Call risk: callable bonds may be redeemed early when rates have fallen, cutting off the higher income.
• Liquidity risk: some bonds, particularly smaller corporate and municipal issues, trade infrequently, which can mean wide bid-ask spreads when selling.

Over long periods, bonds have generally returned less than stocks, reflecting their lower risk and capped upside: the most a bondholder can receive from a bond held to maturity is its scheduled payments.

Bonds vs. Stocks

The distinction comes down to the legal relationship. A stock is a share of ownership in a company, with a claim on its profits and often voting rights, but no ceiling on value and no guaranteed payout. A bondholder owns none of the company, has no vote and gets only the agreed interest. In exchange, bondholders have a contractual claim to payment and rank ahead of shareholders if a bankrupt company’s assets are liquidated.

Because their returns respond to different forces, the two are commonly combined in a portfolio. Bonds provide income and can cushion periods when stocks fall, while stocks supply most of the long-term growth.

FAQs

The Bottom Line

Investors who want income and a cushion against stock declines can use bonds, but rising rates, inflation, default and early calls can all reduce returns. Holding an individual bond to maturity returns face value if the issuer pays as promised, while a bond fund offers diversification without a maturity date. Yield to maturity is the standard measure for comparing bonds with different coupons and maturities.