What Are Bonds: How They Work & How to Invest

Bonds can be an income-generating cornerstone of many modern portfolios. They’re often less risky than stocks, but still riskier than a savings account. They offer diversification and income potential to fine-tune your risk-reward balance. 

But before investing, it’s important to know: what, exactly, are bonds? 

What you need to know

• Bonds are loans that investors make to governments or companies
• Bonds come with specific maturity dates (time to repayment) and interest rates
• Higher-quality bonds have less risk and lower rates; “junk” bonds pay higher rates for more risk
• Investors can mix and match bonds to balance risk, income, and diversification
• Before buying any bond, it’s important to check its credit rating and yield 

What are bonds?

Bonds are fixed-income assets, meaning most offer regular income. Technically, they’re loans between the investor (lender) and the issuing company or government (borrower). The borrower usually pays interest until it’s time to pay the loan in full. 

Investors may buy bonds to create income or diversify away from stocks. However, not all bonds are created equal. Some are more likely to default (not repay their debts) than others.  

That’s the simple definition. Now, let’s unpack the specifics. 

How bonds work

Governments and businesses issue bonds to raise money for goals or projects. Each bond is evaluated for its creditworthiness, which is the likelihood the issuer can repay the loan. In turn, this factors into a bond’s interest rate and risk level.  

Investors who buy bonds lend money to these issuing entities. In exchange, the investor receives periodic interest payments until the bond matures. 

These interest payments usually happen semiannually, but may also come annually or quarterly. Bonds may set fixed or variable interest rates, which can change the income potential. 

After a set period of time, the bond matures or comes due. At this point, the issuer repays the principal, and the loan closes. 

Essential bond jargon

The bond world uses a lot of terms. We’ll touch on some key phrases here. 

• Issue price: The price the issuer sells the bond for (often a “par value” of $1,000)
• Bond price: The price to buy the bond from other investors second-hand, which may differ from the par value
• Par value, face value, or principal: The price the investor receives at maturity, regardless of the issue or bond price
• Coupon rate: The interest rate the issuer pays the investor, based on the face value
• Maturity date: The date the issuer must repay the bondholder’s principal
• Bond yields: A way to measure interest that considers the bond’s fluctuating value
• Secondary market: Where investors trade bonds after buying them from the issuer

Why invest in bonds: pros and cons

Like all assets, bonds carry a unique set of pros and cons to keep an eye on. 

Benefits of investing in bonds

Bonds offer investors several unique benefits, including the ability to:

• Generate relatively stable income via regular interest payments
• Earn higher rates than most savings accounts pay
• Diversify away from stocks and cash, possibly lowering your portfolio’s volatility
• Potentially sell bonds for more than you pay for them (capital appreciation)
• Protect against economic slowdowns and even inflation

Risks associated with bonds

While bonds are generally safer than stocks, that doesn’t mean they’re risk-free! Bond investors should watch out for:

• Credit risk: The risk a bond’s credit rating will fall, resulting in lower prices on the secondary market
• Default risk: The risk the issuer won’t make interest or principal payments
• Interest rate risk: The risk that bond values will fall when rates rise 
• Liquidity risk: The risk you won’t be able to sell your bonds early if you need to
• Inflation risk: The risk you’ll lose purchasing power, since most bonds don’t adjust for inflation
• Call risk: The risk a bond issuer will repay the bond early
  • Not all bonds are “callable”; the issuer should alert you to this fact upfront

Types of bonds

Every type of bond carries its own risks, rewards, and tax implications. Knowing the difference can help you make more informed investment decisions. 

U.S. Treasuries

Treasuries (or “Treasurys”) are bonds issued by the U.S. government. They’re considered some of the safest investments in the world, as the U.S. has never defaulted. Investors can purchase these bonds directly from the U.S. Treasury.

Treasuries come in several varieties: 

• Treasury bills mature in 52 weeks or less. Instead of paying interest, they’re sold for less than their face value and pay their face value at maturity. 
• Treasury notes mature in 2, 3, 5, 7, or 10 years. Notes pay semiannual interest. 
• Government bonds mature in 20 or 30 years. Bonds pay semiannual interest. 

Treasury Inflation-Protected Securities (TIPS) offer a unique trade-off: their value links to inflation. When inflation rises, the principal rises, and vice versa. Many investors use TIPS to counteract periods of high inflation.  

Municipal bonds

States, cities, and other local governments can issue municipal bonds, or “munis.” These bonds raise money for public needs and typically mature in under ten years. 

Investors may buy munis for their tax benefits, as most munis aren’t subject to federal income taxes. (They may also be exempt from local taxes, depending on your location.) However, because of these advantages, munis may pay lower yields than corporate bonds.  

Corporate bonds

Some corporations issue bonds instead of getting a bank loan to fund growth or new projects. Investors can buy these directly from the company or on the secondary market. 

Corporate bonds come in two basic flavors:

• Investment-grade bonds are less likely to default, and so pay lower interest rates
• High-yield or “junk” bonds come with higher default risk but pay higher rates 

Regardless of their credit rating, corporate bond income is taxable at federal and state levels.   

International and emerging market bonds

Investors can also buy bonds from foreign companies and governments. Before going international, though, it’s important to understand potential risk factors. 

In general, developed markets have stronger economies and governments. As such, bonds from these markets tend to boast higher credit ratings. Still, investors should watch out for economic, political, and social risks. 

Bonds from “emerging markets” tend to have lower credit ratings due to factors like:

• Political instability
• Poor corporate governance
• Currency fluctuations
• And/or unstable governments 

Like high-yield U.S. bonds, many pay higher rates to reflect their elevated risk.

Key concepts for bond investments

We’ve already touched on some essential bond jargon. Now, let’s explore the key bond concepts every investor should know.

Bond ratings and credit risk

Bonds are evaluated by credit rating agencies like Moody’s or Standard & Poor’s. A bond’s rating represents its riskiness based on the issuer’s creditworthiness. (However, ratings don’t guarantee returns.)

Investment-grade bonds receive credit ratings of Baa3 (Moody’s) or BBB- (S&P) or higher. Since they’re less likely to default, they generally pay lower rates. 

High-yield or “junk” bonds have lower ratings because they’re more likely to default. They offset some of this risk by paying higher interest rates. Often, lower-rated bonds are issued by younger, foreign, or financially troubled companies. 

Importantly, a bond’s rating isn’t fixed. Credit agencies can upgrade or downgrade ratings if circumstances change. 

Interest rates and bond prices

Bond prices and interest rates move in opposite directions. When rates fall, prices rise, and vice-versa. 

The reason is simple: When interest rates fall, existing bonds suddenly pay a higher rate than new bonds. That can cause existing bond prices to rise as investors seek these higher returns. 

Conversely, higher rates mean that existing bonds aren’t paying as much as new issues. Investors can take this opportunity to buy bonds at a discount compared to their face value.  

Duration and yield-to-maturity (YTM)

Investors should also keep an eye on a bond’s duration and yield-to-maturity. 

Duration here does NOT refer to the time until a bond’s maturity. Rather, duration describes how much a bond’s price will move when interest rates change by 1%. Investors can use duration to compare bonds across face values, coupons, and maturities.  

Yield-to-maturity refers to the total anticipated return if you buy a new bond and hold it until maturity. (Usually expressed as an annual interest rate.) Investors can use YTM to compare bonds of different coupons and maturities.  

How to evaluate bond investments

Before buying bonds, it’s important to do your due diligence. Be sure to evaluate each bond (and how it fits into your portfolio) with care. 

Analyzing market conditions

Current market conditions can change your bond-buying math. Consider factors like:

• Current interest rates. Are they high or low? What kind of rates do investment-grade bonds pay? High-yield bonds? How do they compare to each other?
• Recent or anticipated interest rate changes. Has the Federal Reserve recently moved interest rates? In which direction? Does this present a chance to get better rates or prices on the secondary market? 
• Bond prices. What prices do bonds go for on the secondary market right now? How does that compare to new issues? Could this change soon based on interest rate announcements?

Considerations for financial goals

After evaluating the market, it’s time to match your picks to your financial goals. 

Older investors and those closer to their goals may prefer more bonds than stocks. Bonds tend to be less volatile, which means less risk of loss. That makes them ideal for generating income or slowly growing money you’ve already made. 

Younger investors and those further from their goals may prefer fewer bonds. A stock-heavy portfolio has a chance to build wealth faster, but at a greater risk of loss. 

However, every investor is different. You’ll want to consider your timelines, specific goals, and your risk tolerance. For instance, if you’re risk-averse, you may prefer more bonds than someone your age “should” have. Peace of mind can be worth a lot!

You may also prefer bonds for specific goals where you’re unwilling to risk ANY stock market losses. (E.g., your house-buying fund or car fund.)  

There’s no right or wrong way to choose your bonds. There’s only right and wrong for YOU.  

The role of bonds in a diversified portfolio

Bonds can look “boring,” but they’re an essential component in many portfolios. They offer diversification and steady income potential. Investors can even use them to buy low and sell high. (That is, buying at a discount and receiving face value at maturity.) Plus, they can bring peace of mind during economic turbulence or high inflation. 

But which bonds you buy — and when — matter enormously to your goals and financial outcomes. And once you’re invested, it’s important to keep an eye on them to ensure your decisions continue to serve your needs.