What Are Bonds and How Do They Work?

Amanda Claypool

Writer

Bonds are kind of like the investment world’s version of an IOU. They are a form of debt that a government or a company owes to a person who lends them money. 

What makes them a great investment is that there is a high degree of confidence that they’ll be paid back — with interest. If you’re looking for a safe investment that provides a regular source of income, a bond is a great place to start.

This article will dive into what bonds are, how they work, and whether or not you should consider buying them.

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  • Bonds are fixed-income assets that pay bondholders interest.
  • Bonds are typically issued by the Treasury Department, municipal governments for public works projects, and companies raising funds through debt
  • When a bond reaches maturity, the principal investment is typically returned to the investor in full
  • Bond prices are inversely correlated with interest rates, which can make them useful for diversifying within a portfolio

What are bonds?

A bond is a type of fixed-income asset that is similar to an IOU. Bondholders typically loan money to an issuer, which can be a government or a company. They are a way to raise money to support a company’s operations or for specific public works projects, like infrastructure maintenance. 

In exchange for lending the money, bondholders earn interest payments. There are different types you can buy for varying lengths of time with options for variable or fixed interest payments. When a bond reaches maturity, the principal is returned to the bondholder. 

Pros and cons of bonds

Bonds are typically seen as a low-risk investment that can balance out high-risk assets — like equities — in a portfolio. Diversifying your portfolio with one can help you protect your nest egg when the market is down and interest earned on a bond can provide a stable source of income, especially for someone who is drawing on their portfolio in retirement.

Pros

  • Low risk. Treasury bonds are backed by the government. Since many are issued by the Treasury Department, they are considered safe, as it’s unlikely the government would default on its obligation to repay bondholders.
  • Diversification. Fixed-income assets are a great way to diversify a portfolio and mitigate risk.
  • Liquidity. It can be easily sold and converted into cash.
  • Tax benefits. Depending on the type you purchase, it may help you come tax time. Interest earned from municipal bonds, for example, isn’t taxed at the federal level. Corporate bonds, however, are taxed.
  • Consistent income. Interest payments are a stable source of consistent income. This is especially beneficial during retirement because it’s something you can anticipate and plan around.

Cons

  • Low return. In exchange for being a low-risk asset, bonds typically don’t offer the same potential for returns that you might find in equities or other types of assets, like index funds or exchange-traded funds (ETFs).
  • Inverse relationship with interest rates. When interest rates rise, the value of a bond declines. This can make it difficult to sell one in a secondary market to reinvest it in an asset that provides a higher return.
  • May not keep pace with inflation. Some bonds have long maturity dates. While this might be good when it comes to collecting interest, it might mean your principal has less purchasing power when it’s returned to you after it reaches maturity.

How does it work? 

Bonds are like IOUs that are issued to raise money. Companies use them as an alternative to raising money from venture capital firms while governments use them to finance large public works projects. The bond is a form of debt that the bond issuer has to eventually repay along with interest.

When you purchase a bond you are effectively lending money to the bond issuer. The bond can be purchased for a specific length of time at a particular interest rate to align with the bondholder’s financial goals. When a bond is issued, the bond issuer agrees to repay the principal in full back to the bondholder. This makes a bond a low-risk asset to invest in.

To understand how it works, these are some important key terms you’ll want to know:

Face value

Face value — or par value — is what a bond is worth when it’s issued. Even if interest rates rise, the face value does not. If a bond is issued for $1,000, you are still repaid $1,000 when it reaches maturity. 

Bond coupon

Bonds pay interest to bondholders, and the bond coupon is the interest rate. Typically this is a fixed rate that stays constant for the duration of the bond’s life.

The bond coupon makes interest payments predictable. For example, if you have $100,000 in bonds that earn 5% interest, you can expect to generate $5,000 per year until it matures.

Bond yield

Bond yield measures the value. It can be calculated by dividing the coupon payment by the current price. For example, if you expect to earn $5,000 a year from your bond and the current price is $100,000, the yield is 5%. This represents the return on investment you can expect to generate and is a figure you can compare against other assets, like equities, to see whether or not you’re getting a good return.

Bond ratings

Bonds are rated by credit rating agencies like Moody’s, Standard and Poor’s, and Fitch. Even though it is seen as safe assets, they aren’t completely risk-free. A lower credit rating signifies a higher risk of default, which means the issuer may have trouble repaying a bond when it reaches maturity.

Ratings also inform the yield on high-risk bonds. Those where the issuer is at risk of defaulting — but hasn’t defaulted yet — are known as junk or high-yield bonds. The yield for these tends to be higher due to the higher risk associated with them

How to buy bonds

The easiest way to buy government bonds is directly from the U.S. Treasury through TreasuryDirect. They can also be purchased through brokerage firms. Some, like Fidelity, allow you to purchase individual bonds, while others, like Webull, offer bonds that are bundled together as exchange-traded funds (ETFs).

Depending on your goals, you might consider purchasing bonds as an ETF through a tax-advantaged account like a Roth IRA. Because assets can grow in Roth IRAs tax-free, gains or income generated from assets purchased in a Roth IRA account aren’t taxed.

Types of bonds

There are several types of bonds you can choose from, each coming with varying degrees of risk and returns. The primary types of bonds you’ll come across as an investor are: 

  • Government bonds issued by the Treasury Department
  • Government agency bonds issued by agencies like Fannie Mae and Freddie Mac
  • Municipal bonds issued by state and local governments
  • Corporate bonds issued by companies as a way to use debt to raise funds for ongoing operations

Within the government category, there are different types the Treasury Department issues:

  • Bills: bonds with a maturity date that is a year or less
  • Notes: bonds issued with a maturity date that is less than 10 years but more than one
  • Bonds: bonds issued with more than 10 years until maturity
US Savings Bonds check: Guide on what are bonds and how do they work?

Should I buy bonds? 

Bonds are an important asset to include in a well-diversified portfolio because they allow you to protect your capital and hedge risk regarding volatility. Because they provide regular interest payments, they can also be a stable form of income in retirement.

While investing in it can be good, they do come with some trade-offs. Bondholders are not the same thing as shareholders. If you own a corporate bond you hold a debt obligation with the company but you aren’t entitled to equity if the value of the company increases over time.

Because of that, bondholders tend to earn lower returns than shareholders. This might not be an issue as you get older but if you’re young, you could miss out on decades of higher returns if you don't invest in anything else.

Related: What is risk tolerance?

FAQs

What is a bond fund?

A bond fund is a type of asset that invests in several bonds at once. Examples of bond funds are exchange-traded funds and mutual funds. These kinds of funds expose you to hundreds of bonds at once, allowing you to diversify your portfolio even further.

How do bonds generate income for investors?

It generates income through the bond coupon. This is the amount of interest an investor can expect to earn during the bond's lifetime. Most of them issue interest payments semiannually, creating a dependable and predictable form of interest for bondholders.

How are bonds taxed?

Like other assets, income generated from a bond through interest payments is subject to federal income tax. The exceptions are municipal bonds, which have special tax benefits and aren’t taxed federally. Unlike equities, bonds maintain their face value and typically don’t incur capital gains taxes. In some cases, capital gains may apply if one is being managed by a fund manager and resold on secondary markets.

The important thing to consider with bond income is whether or not it is generated in a tax-advantaged account like a Roth IRA.

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I'm an award-winning lawyer and personal finance expert featured in Inc. Magazine, CNBC, the Today Show, Business Insider and more. My mission is to make personal finance accessible for everyone. As the largest financial influencer in the world, I'm connected to a community of over 20 million followers across TikTok, Instagram, YouTube, Facebook and Twitter. I'm also the host of the podcast Erika Taught Me. You might recognize me from my viral tagline, "I read the fine print so you don't have to!"

I'm a graduate of Georgetown Law, where I founded the Georgetown Law Entrepreneurship Club, and the University of Notre Dame. I discovered my passion for personal finance after realizing I was drowning in over $200,000 of student debt and needed to take action-ultimately paying off my student loans in under 2 years. I then spent years as a corporate lawyer representing Fortune 500 companies, but I quit because I realized I wanted to have an impact; I wanted to help real people and teach them that you can create a financial future for yourself.

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Our aim is to help you make financial decisions with confidence through our objective article content and reviews. Erika.com is part of an affiliate sales network and receives compensation for sending traffic to partner sites, such as MileValue.com. This compensation may impact how and where links appear on this site. This site does not include all financial companies or all available financial offers. This in no way affects our recommendations or article content.

Advertiser Disclosure

Our aim is to help you make financial decisions with confidence through our objective article content and reviews. Erika.com is part of an affiliate sales network and receives compensation for sending traffic to partner sites, such as MileValue.com. This compensation may impact how and where links appear on this site. This site does not include all financial companies or all available financial offers. This in no way affects our recommendations or article content.

Advertiser Disclosure

Our aim is to help you make financial decisions with confidence through our objective article content and reviews. Erika.com is part of an affiliate sales network and receives compensation for sending traffic to partner sites, such as MileValue.com. This compensation may impact how and where links appear on this site. This site does not include all financial companies or all available financial offers. This in no way affects our recommendations or article content.