Bond terminology: What to know before you invest

No matter where you are along your investment journey, bonds can play a vital role in your portfolio. Adding bonds to your asset mix can help you manage risk and secure a regular stream of income.

Before jumping into the market, though, it's important to know what you're getting into. By learning how these investments work and getting familiar with basic bond terminology, you can become a more confident investor.

We'll cover:

• How bonds work
• Key bond terms to know
• Bond valuation terms
• Types of bonds

Bonds are fairly simple investments. A corporation or the government may sell bonds as a way to raise money. You buy the bond, and in exchange, they'll pay you back at a certain date in the future, plus interest. Essentially, you're giving the bond issuer a loan, with the bond certificate serving as an I.O.U. To attract investors, most issuers pay a fixed interest rate to bondholders at regular intervals—typically twice a year.

You can purchase a bond when it's first issued and hold it until it matures. You also can buy and sell bonds on the secondary market, as you would a stock. A particular bond's value will go up or down until it reaches maturity, depending on many factors. For example, interest rate changes or the issuer's ability to pay creditors may change demand for the bond and cause its price to fluctuate.

In general, bonds are considered less volatile than stocks, which is why many investors use them to reduce risk in their portfolios. However, there's a chance the issuer won't be able to pay you back when the maturity date rolls around. Or, the bond's price may have decreased on the secondary market. It's important to look at many factors, including the issuer's financial health and the length of time until maturity, before deciding whether the bond carries an acceptable level of risk.

If you're new to bond investing, understanding some basic concepts can help you make informed decisions about these tradeable securities.

The company or government that sells the bond. The issuer promises to pay interest at specific intervals and to repay the bond's face value at the end of the bond's term. Public issuers may include federal, state or local governments, as well as international finance institutions such as the World Bank.

The date when the issuer agrees to pay back the bond's face value to the buyer. Bonds often are described as short-, medium- or long-term, depending on the time remaining until they reach maturity.

The amount the issuer agrees to pay the investor when the bond reaches maturity, also known as par value or principal. The face value and the sale price may be the same. Or, the bond may sell for more or less than its face value based on interest rate movements across the economy.

The annual interest rate that the issuer agrees to pay the bondholder. The coupon rate—or coupon yield—is generally fixed for the bond's duration. For example, a $1,000 bond with a 4% coupon rate pays the investor $40 a year in interest. In general, bonds with a shorter maturity offer a lower coupon rate because there's a lower risk the issuer will default or that interest rates will rise significantly before maturity.

The date the issuer agrees to pay interest to its bondholders. Typically, coupon dates occur every six months after the bond was issued, but the interval can vary across issuers.

The date the bond is first offered to investors on the primary market and it begins to accrue interest. The buyer has to pay the issuer any interest accrued between the issue date (aka the dated date) and its settlement date (when the actual sale takes place). However, the buyer receives the full interest payment from the issuer when the next coupon date arrives.

An issuer's inability to make scheduled interest payments or pay the bond's full face value at maturity. A default can be relatively harmless when an issuer faces a short-term cash flow problem and misses an interest payment by a few days or weeks. However, it's more troubling if the issuer faces substantial financial challenges and can't make the missed payments in the foreseeable future. In this case, the company may have to declare bankruptcy, and bondholders may not receive the amount they're owed.

A securities dealer that purchases bonds from the issuer and resells them to investors at a profit. While their primary role is to bring newly issued bonds to market, underwriters also may advise the issuer around the bond's timing and structure. Often, a group of investment banks form an underwriting syndicate to split up the purchase of a bond issue.

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How bond laddering works

Bonds are relatively stable investments, but you still have risks to consider before investing in these fixed-income securities. A bond ladder strategy could help you manage risk while taking advantage of higher yields.

Dive deeper

Because interest rates are constantly changing, bond values change, too. Understanding these key terms can help you determine whether a debt security offers a competitive return compared to other investment choices.

The price the bond sells for on the primary market. In some cases, the issue price and the face value differ. With some new bond issues, you pay less than face value. The "discount" is then added to the interest you receive when calculating your total return.

The sell price amount below the bond's face value. For example, if a one-year bond with a $1,000 face value offers a 5% coupon—and interest rates across the economy increase—investors only may be willing to pay $990 for it. Because it's selling "at a discount," the buyer gets a higher potential return than the coupon rate. It's also comparable to other securities offered at the time.

The amount above the bond's face value buyers are willing to pay. Typically, a bond sells "at a premium" when interest rates decrease and its coupon now looks favorable to similar-quality bonds with the same maturity. Because it sells for more than the face value, the bond delivers a lower yield than the coupon rate.

A measure of how sensitive a bond's price is to interest rate changes, expressed in years. To identify the duration, you calculate the present value of all future income from the bond, including coupon payments and the bond's face value. Bonds with a higher duration generally lose more of their value when interest rates increase. For example, if a bond has a 10-year average duration and interest rates go up 1%, it may lose about 10% of its value.

A numerical value, equal to 1/100th of 1%, often used to express a change in interest rates. For example, if a bond issuer lowers its coupon rate from 5% to 4.75%, it represents a 25-basis point reduction.

The annual rate of return a buyer can expect to receive from a bond. To determine the current yield, you divide the coupon rate by the bond's current market value. If the bond's value changes, the current yield moves up or down accordingly.

The annual rate of return an investor receives if they buy a bond and hold it until the maturity date, including expected interest payments and the return of principal at maturity. While the coupon rate affects the yield to maturity, the two figures are only the same if the bond was purchased at face value. If the investor buys a bond at a premium, for example, the yield to maturity is less than the coupon rate—and vice versa.

A grade a credit rating agency, such as A.M. Best, Moody's, Fitch or Standard & Poor's, assigns to a bond issue. The rating agencies analyze the issuer's financial data and gauge its ability to pay bondholders and other creditors on time. Higher bond ratings indicate a stronger confidence the issuer may not default, which generally means the issuer can borrow at lower interest rates.

Not all bonds are alike. Learning how these securities vary based on credit quality and their unique features will help you choose the right ones for your portfolio.

Bonds that receive high grades from credit rating agencies. Bonds with a rating of "Baa" or higher by Moody's or "BBB" and above by Fitch and Standard & Poor's are considered investment-grade debt. Corporations and governments that offer investment-grade bonds are believed to have a lower risk of default than other issuers, making them preferred by investors interested in preserving capital. However, they tend to provide lower yields than bonds with a lower credit rating.

High-yield bonds are issued by corporations or governments with a greater probability of defaulting. Also known as junk bonds, non-investment-grade bonds or speculative bonds, these securities offer a higher potential return to attract buyers. They're best suited to investors with a high risk tolerance. Bonds rated "Ba" or lower by Moody's and "BB" or lower by Fitch and Standard & Poor's are considered high-yield.

A bond that allows the issuer to call (i.e., repurchase) the security at a specific date prior to maturity. The issuer must pay the investor the call price, which is often the bond's face value plus any accrued interest. Because issuers tend to redeem bonds when interest rates are lower than the coupon rate, bondholders may have to purchase new bonds that offer a lower yield. To make up for this possibility, known as bond call risk, these securities generally pay a higher coupon rate than noncallable debt securities.

Bonds that don't pay interest. The investor gains a return by purchasing the bond at a significant discount and receiving the face value at maturity. Even though investors don't receive coupon payments, they still have to pay annual tax on imputed interest—the prorated difference between the bond's face value and what the buyer paid for it.

Compared to fixed-rate bonds, floating-rate bond coupons may be reset at certain times or periodically, such as quarterly or semi-annually. Coupon adjustments often are tied to changes in an underlying index such as the prime rate or the Secured Overnight Financing Rate (SOFR). Resets often follow changes in market interest rates, meaning the next coupon may be higher or lower than the previous coupon.

Corporate bonds that give the investor the right to convert the bond into shares of common stock at a specific date. The bonds specify the number of shares the buyer can receive per bond if they decide to convert it. Because they offer more flexibility than other fixed-income securities, convertible bonds generally offer a lower coupon rate than nonconvertible bonds.

A type of bond issued by the U.S. Treasury Department that offers higher returns during periods of steeper inflation. For example, Treasury inflation-protected securities (TIPS) have a unique feature where the par value is pegged to changes in the Consumer Price Index (CPI). Series I savings bonds, or I bonds, are also inflation-protected bonds. The interest payments on I bonds are adjusted twice a year based on inflation, providing a hedge against price increases.

Bonds issued by states, counties, cities and other local government bodies. Issuers use the revenue from municipal, or muni, bonds to fund ongoing expenses or large projects, such as constructing new roads or public buildings. The interest on most municipal bonds is exempt from federal tax and may be exempt from state income tax for residents of the bond issuer’s state. Tax-free munis generally offer lower returns than other bonds of a similar credit quality.

Bonds can play an important role in your financial strategy, helping you diversify your assets and potentially giving you a regular stream of income. While generally considered safer than stocks, these securities aren't bulletproof. Learning basic bond terminology can help you understand the potential risks and rewards so you can invest with more confidence.

If you're still not sure how much of your portfolio to allocate toward fixed-income securities or what type to buy, a local financial advisor can help. Based on your needs, they can recommend a tailored investment strategy that gets you closer to your goals.