What are a bonds and how do they work?

In a nutshell

Bonds are considered a necessary part of a well-balanced investment portfolio because they preserve capital and provide steady income.

• A bond is a debt security issued by a company or government.
• It provides both the safety of principal and predictable interest income throughout the term.
• Bonds can both rise and fall in market value before they mature.

What is a bond?

A bond, like a stock, is a type of investment security. However, unlike stocks, which represent shares of ownership in the issuing company, bonds are debt obligations. They can be issued by private or publicly traded corporations, foreign and domestic governments, and government agencies.

As debt obligations, bonds represent a promise to pay back the bond owner. The issuer sells the bond at a specific price, promising to pay the full face value of the bond upon maturity (plus annual interest at a fixed rate throughout the duration).

At the end of the term, the issuer redeems the bonds from investors, and the debt is then canceled.

Bond terms to know

Like virtually every other investment security, bonds have their specific terminology. Here are some common terms related to bonds:

• Term: This is the length of time the bond will be outstanding, which typically ranges from 15 to 30 years.
• Maturity: This is the date upon which the bond will be redeemed by the issuer.
• Coupon or nominal rate: This is the rate the issuer will pay on the bond issue.
• Price: Though a bond may be issued with a $1,000 face value, the market value will fluctuate before maturity. A bond may have a market price of 95 ($950) or 105 ($1,050) depending on a combination of prevailing factors at the time of purchase.
• Effective yield or APY: This is the net return on a bond when market value is factored into the equation. For example, a bond with a coupon rate of 5% will reflect a higher yield if it is purchased at $95 than if it is purchased at the full face value of $100. (These dollar amounts are for illustrative purposes only.)
• Credit risk: This is the projected risk that the bond issuer will default and fail to pay interest on the bond (or even fail to redeem it upon maturity).
• Interest rate risk: Bonds have an inverse relationship with interest rates. When rates rise, the market value of bonds falls. When interest rates fall, the market value of bonds increases.
• Commissions: This is a fee bond investors are required to pay investment brokers when purchasing a bond.
• Callable feature: Corporate bond issuers may issue bonds with a call provision. This gives the issuer the right to call in the bond early, which usually happens in circumstances that are advantageous to the issuer.
• Convertible bonds: Issued by corporations, convertible bonds contain a provision specifying that they will be converted to common stock of the issuer at specific intervals. This provision usually results in a lower bond coupon rate.

This is not a complete list of all terms related to bonds, but it does include those that are most common and relevant.

How bonds work

A bond issue will be offered by the issuer, which can be a corporation or a government agency. For example, a company might sell $100 million worth of twenty-year bonds with a 5% interest rate. The bonds will be sold in denominations of $1,000, with interest payments made at regular intervals until maturity. When the bond finally matures, the issuer will pay bondholders the face amount of the bonds.

A company or government may issue bonds for a variety of reasons. One reason might be for capital improvements: the issuer will raise capital through the issuance of bonds to pay for the construction of major projects, like office buildings, factories or in the case of governments highways and schools. In other cases, bonds can be issued to pay off existing debt or to acquire ownership of property or another business entity.

Bonds are typically sold at face value at the time of initial issuance. The subsequent resale value of the bonds will fluctuate due to market forces. Existing bonds are commonly bought and sold through investment brokers.

At the time of issuance, the interest rate paid on a bond will be determined by a combination of the interest rates of the general market and the financial strength of the bond issuer. For example, if the general rate for 20-year corporate bonds is 5%, a company with a strong credit rating may issue its bonds at 4.5%, while a company with a below-average credit rating may need to pay 6%.

The credit rating of the bond issuer is determined by credit rating agencies, such as Moody’s and Standard & Poor’s. Bonds carrying a grade of A or better (AA, AAA) are considered investment-grade bonds and have the lowest rates. Bonds with ratings of BBB or lower pay progressively higher rates because of the increased risk of issuer default.

Types of bonds

There are three primary types of bonds:

• Corporate bonds: These are bonds issued by publicly traded companies.
• U.S. Treasury bonds: These are bonds issued by the U.S. government in denominations of $100, with terms of 20 or 30 years.
• Municipal bonds: These bonds are issued by states and local governments. They are generally tax-exempt both at the federal and at the state level.

Both corporate and government bonds can be issued by companies and governments in other countries.

There are two broad categories of corporate bonds: investment grade and high-yield bonds. Investment-grade bonds carry high ratings from credit agencies, which also means they pay lower rates. High-yield bonds pay higher interest rates because they have lower credit ratings. The higher interest rate is to compensate for the greater likelihood of default.

Municipal bonds can be classified as “general obligation” or “revenue” bonds. General obligation bonds are paid out of the general financial resources of the issuer, while revenue bonds are paid with income flows generated by specific projects that are financed by the bonds.

The benefits and risks of bonds

How to buy bonds

Bonds can be purchased through investment brokers. Unlike stocks, which commonly trade commission-free, brokers charge fees for bond trades. For example, Public charges fees on bonds,ranging from $0.10 to $0.50 per $100 of the face value of the bonds, depending on the type of bond you are buying or selling.

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Fees

U.S.-listed stocks and ETFs, commission-free; after-hours trades and over-the-counter (OTC) trades, $2.99 per trade; crypto fees range from $0.49 on orders up to $10 to 1.25% of trades greater than $500; Treasuries, 0.05% per month of your Treasury investment.

Min. deposit

$0 to open an account, $5 to begin trading

Buying bonds directly usually requires a minimum of $1,000 per bond or the current market value of the bond on the secondary market. However, it is possible to invest in bonds with less money. This is commonly done by investing in bond exchange-traded funds (ETFs), which can be purchased for as little as the current share price of the ETF or even a fraction of the share price. (This is known as fractional shares.)

Another alternative is to purchase U.S. Treasury bonds through the Treasury Department’s bond portal, TreasuryDirect. Treasury bonds can be purchased with terms of 20 or 30 years and in denominations of $100. Interest rates on Treasury bonds are usually a bit lower than the highest-rated corporate bonds because the U.S. government has the highest credit rating of any issuer.

How to choose a bond

The way you choose a bond will depend on what it is you expect it to do in your portfolio. If you’re looking for safety in principal payments, and predictable income, you might invest in bonds with the highest credit ratings. Those will generally be either AAA- or AA-rated bonds. It may also include U.S. Treasury bonds, all of which carry a AAA rating.

This type of bond has the best chance of providing balance in your portfolio in the event your stocks start to waver in value.

If your primary concern is income, you may want to choose bonds with a slightly lower rating, such as BBB or BB. Even higher rates are possible with credit ratings in the C range. But these bonds also carry an above-average risk of default, which means you may not be repaid upon maturity or the issuer may default long before the bonds mature.

Duration is an important consideration as well. If you believe interest rates have peaked, you’ll want to purchase bonds with the longest terms. That will give you an opportunity to lock in a superior rate for as long as 30 years. If you believe rates will increase, you may want to purchase shorter-term bonds. For example, you can purchase a 20- or 30-year bond with five years remaining on the term. Because it will mature in just five years, the market value of the bond will be less likely to react negatively to rising rates.

Bond investment strategies

A common bond investment strategy is buy-and-hold, which is very similar to holding stocks for the long term. In this strategy, bonds are purchased for capital preservation and income generation. This strategy is popular among retirees because it generates predictable income with less risk to your principal.

It’s also possible to use various trading strategies with bonds. Because of their long duration, 20- and 30-year bonds can behave in a similar way to stocks. They can rise in value when interest rates fall, and decline in value when rates rise.

A trader might attempt to exploit changes in interest rates using bonds. Holding a long position in a bond could produce a profit when interest rates are falling. In a rising rate environment, the bond trader can short-sell bonds to take advantage of the decline in market value.

Trading bonds in this way is high risk because it’s very difficult to predict the direction of future interest rates and exactly how much they will impact the market value of bonds.

The AP Buyline roundup: Bonds for a balanced portfolio

Because they provide a predictable cash flow and capital preservation, bonds are widely considered to be a good diversification strategy alongside stocks. Allocating a portion of your portfolio to bonds can improve long-term performance by reducing the impact of declines in stock prices.

For that reason, nearly every investor should hold at least some of their portfolio in bonds. The percentage should be lower when you are younger to allow for a larger allocation of stocks because of the growth they provide. For older investors, especially retirees, a larger bond allocation is typically recommended because it places greater emphasis on income generation and capital preservation.

Frequently asked questions (FAQs)

Is a bond just debt?

At its core, a bond is a debt to the issuer. But it’s also an asset to the bondholder because it receives a promise to pay the full face value of the bond upon maturity as well as payments of interest for every year the bond is outstanding.

How do bonds lose value?

The most common reason bonds lose value is because of interest rate risk. Because bond values have an inverse relationship with interest rates, their market value will fall when interest rates rise. The bondholder will still be paid the full face value of the bond upon maturity but can lose money by selling the bond before.

A second cause is a downgrade in the credit grade of the issuer by the rating agencies. If the bond issuer's rating falls from AA to BBB, the market value of the bond will decline to reflect a higher yield on the bond. The higher yield compensates for the increased risk of default.

Can you lose money on bonds if held to maturity?

If a bond is held until maturity, you will be repaid the full face value of the security — at least in nominal terms. However, because a bond can run for a term as long as 30 years, a $1,000 bond issued in 2024 will not be worth $1,000 at maturity in 2054 if you analyze its future purchasing power. Though the bond is purchased at $1,000, its purchasing power will drop to approximately $412 with an average inflation rate of 3% over 30 years.