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.
They're also a great investment, since there's 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.
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What Are Bonds?
A bond is a type of fixed-income asset that is similar to an IOU. Bondholders loan money to an issuer, which can be a government or a company.
Bonds are a way for an organization to raise money to support their 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.
Buying bonds can help you diversify your portfolio and protect your nest egg when the market is down. Plus, interest earned on a bond can provide a stable source of income, especially if you're drawing on your portfolio in retirement.
But there are a few things to consider before you invest in too many bonds.
| Pros | Cons |
|---|---|
| Low risk. Treasury bonds are backed by the government, and it’s unlikely the government would default on its obligation to repay bondholders. | Low return. Bonds typically don’t offer the same potential for returns that you might find in other types of assets, like index funds or exchange-traded funds (ETFs). |
| Liquidity. Bonds can be easily sold and converted into cash. | Inverse relationship with interest rates. When interest rates rise, the value of a bond declines. |
| Tax benefits (depending on the bond type). Interest earned from municipal bonds isn’t taxed at the federal level. (Corporate bonds, however, are taxed.) | May not keep pace with inflation. Some bonds have long maturity dates. This might mean your principal has less purchasing power when it’s returned to you at maturity. |
| Consistent income. Interest payments are a stable source of passive income, which can be especially beneficial during retirement. |
How Do Bonds Work?
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.
When a bond is issued, the bond issuer agrees to repay the principal in full 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 to know:
- Face value (par value): What a bond is worth when it’s issued. Even if interest rates rise, the face value doesn't. If a bond is issued for $1,000, you are still repaid $1,000 when it reaches maturity.
- Bond coupon: The interest rate. Typically, this is a fixed rate, which 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: The value, 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%. You can compare this against other assets to see whether 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 bonds are 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.
RELATED: What Is Risk Tolerance?
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 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, any gains or income generated in the account aren't taxed.
Types of Bonds
There are several types of bonds you can choose from, each 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 that the Treasury Department issues:
- Bills: Bonds with a maturity date that is a year or less
- Notes: Bonds with a maturity date that is less than 10 years but more than one year
- Bonds: Bonds with more than 10 years until maturity
RELATED: How To Buy I Bonds to Protect Your Investment Portfolio
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?
Bonds generate income through the bond coupon. This is the amount of interest you can expect to earn during the bond's lifetime. Most issue interest payments semiannually, creating a dependable form of income for bondholders.
How are bonds taxed?
Like other assets, income generated from a bond 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. But in some cases, capital gains may apply if a bond is being managed by a fund manager and resold on secondary markets.
The important thing to consider with bond income is whether it's generated in a tax-advantaged account like a Roth IRA.
TL;DR: 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. And since they provide regular interest payments, they can also be a stable form of income in retirement.
But 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, as you would be with stocks.
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.
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