What is a bond
A bond is a loan. When you buy a bond you lend money to an issuer. The issuer can be a government, a city, or a company. In return the issuer promises to pay interest and to return the loan amount at a set date.
Bonds are one of the main ways governments and companies raise money. For investors they are a way to earn regular income and reduce portfolio risk compared to stocks.
Simple parts of a bond
- Face value or par value: The amount the issuer will repay at maturity. Usually $1,000 for corporate bonds.
- Coupon: The interest paid, usually as a percent of face value. A 5% coupon on a $1,000 bond pays $50 a year.
- Maturity: The date when the issuer must repay the face value.
- Price: What you pay today. It can be above or below face value.
- Yield: The return you get based on price and payments. There are different yield measures.
- Credit rating: An agency grade that shows how likely the issuer will repay.
How bonds pay you
Most bonds pay interest periodically. Common schedules are annual or semiannual. At maturity you also get back the face value. So a bond gives you:
- Regular income from coupons.
- Return of principal at maturity, unless the issuer defaults.
Price and yield, and why they move
Bond price and yield move in opposite directions. If market interest rates rise, existing bond prices fall. If market rates fall, existing bond prices rise.
Why? A bond with a fixed coupon is less attractive when new bonds pay more interest. To match the market the price drops so the yield goes up.
Yield to maturity made simple
Yield to maturity, or YTM, is the total return you would get if you buy the bond and hold it to maturity, assuming the issuer makes all payments.
A quick approximate formula: (annual interest + (face value - price) / years to maturity) / ((face value + price) / 2)
Example:
- Face value $1,000
- Coupon 5% = $50 per year
- Price $950
- 5 years to maturity
Plug in: (50 + (1000 - 950) / 5) / ((1000 + 950) / 2) = (50 + 10) / 975 = 60 / 975 ≈ 6.15%
That 6.15% is a practical estimate of the bond's YTM.
Main types of bonds
- Government bonds: Issued by national governments. Treasuries in the US are very safe.
- Municipal bonds: Issued by states, cities, and local agencies. Often tax-exempt at the federal level.
- Corporate bonds: Issued by companies. Higher yield than government bonds but higher risk.
- Agency bonds: Issued by government-related agencies.
- High yield or junk bonds: Issued by lower rated companies. They pay more interest to compensate for higher default risk.
Common risks
- Interest rate risk: Prices fall when market interest rates rise.
- Credit or default risk: Issuer might fail to pay interest or principal.
- Inflation risk: Fixed payments lose buying power if inflation rises.
- Liquidity risk: Some bonds are hard to sell quickly without losing money.
- Reinvestment risk: Coupon payments may need to be reinvested at lower rates.
Special features
- Callable bond: The issuer can repay the bond early. This helps issuers when rates fall but hurts bondholders.
- Convertible bond: Can be converted into stock under set conditions.
- Zero coupon bond: Pays no periodic interest. It is sold at a deep discount and repays face value at maturity.
Taxes
- Interest from corporate and most municipal bonds is taxable at the federal level.
- Interest from municipal bonds is often exempt from federal tax. Some are also exempt from state tax if you live in the issuing state.
- Treasury interest is exempt from state and local tax, but not from federal tax.
How to buy bonds
- Directly through a broker.
- Buy bond funds or ETFs to get many bonds at once and improve liquidity.
- For U.S. Treasuries use TreasuryDirect to buy directly from the government.
When people choose bonds
Investors use bonds when they want income, lower volatility, or capital preservation. Bonds are useful for income portfolios, for diversifying away from stocks, and for matching liabilities like future payments.
Quick comparison with stocks
- Bonds are loans. Stocks are ownership.
- Bonds usually pay fixed interest. Stocks may pay dividends that can vary.
- Bondholders have priority over shareholders if a company fails.
- Stocks offer higher long-term growth potential and higher volatility.
Final takeaway
A bond is a promise to repay money with interest. It is simpler than stocks and useful for income and safety. But bonds are not risk free. Understand coupon, maturity, price, yield, and credit quality before you buy.
Common questions
- Are bonds safe? Government bonds are safer than corporate bonds, but no investment is risk free.
- Do bonds always pay interest? Most do. Zero coupon bonds do not pay periodic interest.
- Should I buy individual bonds or a bond fund? Funds give diversification and liquidity. Individual bonds let you hold to maturity and know your cash flows.
If you want, I can show a simple bond ladder example and how it reduces interest rate risk.