Bonds are fixed-income investments where investors lend money to governments, corporations, or municipalities in exchange for regular interest payments and the return of principal at maturity. Understanding how bonds work helps investors manage risk and generate steady income.
What Are Bonds?
Bonds are fixed-income securities that function as loans made by investors to governments, municipalities, or corporations. In exchange for lending money, investors receive regular interest payments and get their principal back at maturity. Bonds are a key investment tool for generating income and balancing risk in a portfolio.
How Bonds Work
Issuing and Buying Bonds
When an entity needs funding, it issues bonds to raise capital. Investors purchase these bonds, effectively lending money to the issuer. In return, the issuer pays periodic interest, known as the coupon, until the bond matures.
Key Bond Terms
- Face Value (Par Value) – The amount repaid to the investor at maturity, usually $1,000 per bond.
- Coupon Rate – The interest rate the bond pays annually, based on the face value.
- Maturity Date – The date when the bond’s principal is repaid.
- Yield – The return an investor earns from a bond, which fluctuates based on price and interest rates.
Types of Bonds
Government Bonds
Issued by national governments, these bonds are considered low-risk investments. Examples include U.S. Treasury Bonds, Treasury Notes, and Treasury Bills.
Municipal Bonds
Issued by cities, states, and other local governments to finance public projects. Some municipal bonds offer tax-free interest income.
Corporate Bonds
Issued by companies to raise capital for operations, expansion, or debt refinancing. Corporate bonds typically offer higher yields than government bonds but carry more risk.
Zero-Coupon Bonds
These bonds do not pay periodic interest. Instead, they are sold at a discount and pay the full face value at maturity.
Bond Pricing and Interest Rates
How Bond Prices Are Determined
Bond prices fluctuate based on interest rates, credit ratings, and supply and demand. When interest rates rise, bond prices fall, and when interest rates drop, bond prices increase.
Relationship Between Bonds and Interest Rates
Since new bonds are issued with current interest rates, older bonds with lower coupon rates become less attractive when rates rise, decreasing their price. Conversely, when rates fall, older bonds with higher coupon rates become more valuable.
Risks of Investing in Bonds
Interest Rate Risk
Bonds lose value when interest rates rise. Investors holding long-term bonds are more exposed to this risk.
Credit Risk
If the issuer defaults, bondholders may not receive interest payments or their principal back. Corporate bonds generally carry higher credit risk than government bonds.
Inflation Risk
Inflation erodes the purchasing power of fixed interest payments, reducing real returns for bondholders.
How to Invest in Bonds
Buying Individual Bonds
Investors can purchase individual bonds through brokers, directly from the U.S. Treasury, or in bond auctions.
Investing in Bond Funds
Bond mutual funds and exchange-traded funds (ETFs) provide diversification by investing in a portfolio of bonds. These funds offer liquidity and professional management.
Building a Bond Ladder
A bond ladder involves buying bonds with staggered maturities to reduce interest rate risk and create a steady income stream.
Understanding bonds helps investors make informed decisions about income generation, risk management, and portfolio diversification.