Bonds are loans from an investor to a borrower, who is typically a company or government entity. When these companies and governments (from the U.S. Treasury to your local town board) need money for major projects, one way they finance them is by selling bonds.
How Bonds Work
When you invest in a bond, you essentially become a lender to the entity that issued it; the bond is a promise to pay back the loan after a set period of time—the bond's term or maturation period. Bonds can have maturity periods of any duration, but most range from one to 30 years.
Most bonds are offered in increments of $1,000. Increments of $5,000 or as small as $100 are not uncommon, and some bond issues have much higher increments, aimed at attracting institutional investors such as pension fund managers. The face value of a bond, also known as its par value, is the amount the issuer will pay the bondholder on the bond's maturation date.
Bonds are traded on open exchanges, much like stocks, and their market price can fluctuate above and below their par values. (See below for more on what affects bond pricing.)
Bonds also include a pledge to pay you interest on your loan, at a rate known as the bond's coupon. The coupon is an annual interest rate, which is usually delivered in payments every six months. Current coupons on U.S. Treasury bonds range from 0.75% on a two-year bond to 1.88% on a 30-year-bond.
Like any other investment vehicle, bonds come with some risk, but they are generally considered safe, reliable investment options. The return on a bond is steady and predictable: If you buy one when it is issued and hold it until maturity, you can calculate exactly what the yield will be. The return on bonds tends to be relatively lower than other investments such as stock or real estate.
From 1980 to 2019, long-term U.S. government bonds (those with maturity periods of 10 years or more) yielded an overall return of 5.64% after adjustments for inflation, while adjusted returns on stocks in large U.S. companies were 8.48% for the same period, according to Morningstar Inc., a financial services company.
Types of Bonds
There are three main types of bonds, distinguished by the entities that issue them and attributes specific to each:
- Treasury bonds, or "T-bonds," are issued by the federal government and backed by its "full faith and credit," so they are considered extremely safe investments. Gains you receive through T-bonds are exempt from state and local taxes, but federal income taxes still apply. Unlike other bonds, which are offered for purchase at par value the day they are issued at preset interest rates, the offer price and coupon rate for Treasury bonds are determined through an auction process.
- Municipal bonds are sold by communities and counties to fund large-scale construction of schools, highways, water-treatment plants and the like. Income generated by many (but not all) municipal bonds is tax-exempt.
- Revenue bonds are municipal bonds used to fund projects that are expected to generate money, such as toll roads, hospitals and airports. They pay back bondholders from their projects' income streams, and if that income fails to meet expectations, bondholders could be out of luck. General obligation municipal bonds are backed by the full faith and credit of the authority that issues them, which means they must be paid by any means possible, including by raising taxes.
- Corporate bonds are offered for sale by companies to fund a wide range of projects, from building new facilities to research and development to acquisition of other companies.
- High-yield bonds are a subcategory of corporate bonds sometimes called junk bonds. They come with significant risk of default, and may not be easy to trade, but they offer higher interest rates than most other corporate bonds.
- Some corporate bonds are classified as callable, which means the issuing company has the option of retiring the bond by paying out its par value before its maturity date. Doing so means the bond will yield less interest than if it were allowed to fully mature. This is a risk bond investors must consider before purchasing callable bonds. Callable bonds typically offer higher interest rates than comparable non-callable bonds, to offset that risk.
Big investors who buy bonds often offer them for sale in secondary marketplaces, where they are traded much like commodities and stocks. Depending on its age and prevailing market conditions, a bond can trade at a price well above (or below) its par value. Prices of municipal bonds, T-bonds and corporate bonds (other than high-risk bonds) are published daily in financial newspapers and websites.
Factors that affect the trading price of a given bond include:
- Market interest rates: Changes in prevailing interest rates affect a bond's relative value as an investment over time. When interest rates decline during a bond's maturity period, the bond's price will tend to increase, because its yield will compare favorably with those of newer bonds and interest-bearing investments. On the other hand, if interest rates increase as a bond matures, its trading price could fall, as newer bonds offering higher coupon rates offer greater appeal.
- Time to maturity: As a bond approaches its maturity date, the number of interest payments it will yield diminishes, and that can diminish its market value.
- Bond credit ratings: The three main bond credit rating agencies, S&P Global, Moody's and Fitch Group, assign bond issuers ratings that can be compared to individual borrowers' credit scores. These agencies sometimes adjust ratings to reflect perceived shifts in an issuer's economic health. If an issuer's rating drops, that tends to lower a bond's market price, while a rating boost could increase its trading price.
Pros and Cons of Investing in Bonds
The main advantage of investing in bonds is that they're as close to a sure thing as you can get: In most cases, if you buy and hold a bond until maturity, you know what your return will be. Economic trends such as inflation and interest rate fluctuations can affect all investments, but swings in bond prices and yields tend to be less volatile than those of stock or real estate.
The chief disadvantage of investing in bonds is that those returns will be relatively modest, especially in comparison to stocks and real estate. If purchased on its issue date and held until maturity, a $1,000 20-year bond with an interest rate of 1% would yield $20 per year or $400, for a 40% gain. By contrast, if you'd invested $1,000 in superstar stock Apple Inc. in 2001, it would be worth hundreds of thousands of dollars today.
Of course, not all stocks are superstars; returns over the past 20 years are no guarantee of future performance, and the stock market typically sees significant ups and downs during any 20-year span. That's why many financial professionals advise combining stocks and bonds in retirement investment portfolios. The idea is to rely on the relative certainty of bond yields, while pursuing more significant gains by growing your stock holdings. It's not unusual for portfolio managers to recommend buying stocks early in your working life, and then shifting emphasis to less risky bonds as you get closer to retirement age.
As with any investment decision, when considering bond purchases, it's wise to discuss your goals and risk tolerance with a professional advisor who can steer you toward offerings that meet your needs.