As you explore and establish ways to build wealth and save for retirement, you may wonder about holding bonds for investment. Bonds are one of many investment options to consider in addition to things like stocks, real estate, mutual funds, exchange traded funds (ETFs) and certificates of deposit (CDs).
For a long time, bonds have been considered a conservative, reliable avenue for achieving long-term financial goals in a steady way. They can bring diversification to your investment portfolio.
If you're new to investing in bonds, read more about how they work before diving in. In this article, we'll explore:
What are bonds? How do bonds work? What are common types of bonds? What are bond credit ratings? Should you invest in bonds?
What are bonds?
Bonds are debt contracts that governments and companies use as a way of raising money. A bond essentially represents a loan that they must pay back after a set period of time, and as the bondholder, you're the lender or creditor. In contrast to stockholders
This type of investment is generally considered to be conservative. The interest on bonds is a relatively low but fixed rate, and interest payments to bondholders usually are made once or twice a year during the length of the bond, making them predictable. Plus, their default risks tend to be low—government bonds in particular have full faith and credit backing—making them more reliable than other investments.
Key terms to know when investing in bonds
Before discussing how bonds work, it helps to know the terminology. Here are some of the most common definitions to become familiar with:
- Issuer. The organization or entity that creates the bond and borrows money.
- Principal. The amount of money the issuer borrowed and has to repay; also called face value or par value.
- Maturity. The length of time a bond will be in force; at maturity, the principal is repaid to the bondholder.
- Current value. The price the bondholder would receive for selling it on the open market.
- Premium. A bond with a current value higher than its principal.
- Discount. A bond with a current value lower than its principal.
- Coupon rate. The interest rate stated in the bond contract.
- Coupon payment. The interest the bondholder receives, usually twice per year; the principal amount multiplied by the coupon rate determines the coupon payment.
- Yield. Another way of defining what a bond pays; for example, the "coupon yield" is simply the coupon rate, but "current yield" is the total annual interest and dividends received by the bondholder divided by the bond's current value.
How do bonds work?
Governments and corporations seeking to issue bonds publicly have to go through certain securities regulatory legwork before their bonds can be sold. Once they're available, you may be able to buy them directly from the issuer—that's the main way to get
When you buy the bond, it will come with a maturity date and the details on when you'll get coupon payments, usually annually or semiannually. Depending on the type of bond, you'll likely be taxed on this interest income at your ordinary tax rate, but you're free to use this payment stream for any purpose. There are also "zero coupon bonds." With these, you'll receive all the interest with the principal at maturity rather than getting regular interest payments.
Another factor to consider when trading in bonds is accrued interest. Given that bonds typically pay interest semiannually, if a bond is bought or sold at a time other than on an interest payment date, the purchaser will have included in the purchase amount any interest accrued since the previous interest payment. This occurs because the seller is entitled to interest accrued up to the trade settlement date. The purchaser will then receive the full periodic interest payment at the next payment date.
Here are a couple of scenarios you may need to think about before the maturity date arrives:
- Selling the bond. You may need or want to sell the bond on the secondary market before it matures. When you sell it for market value, you may get more than you paid in principal or less, and you will no longer receive the interest payments.
- Callable bonds. Certain bonds are callable, meaning that the issuer can redeem them early. Because of this possibility, these bonds usually pay higher interest rates. They're not the best choice if you're counting on regular cash flow because you can't control if or when the bond is called.
Those exceptions aside, if you've hung onto the bond until its maturity date, it then becomes due. This means you can get your principal amount back from the issuer plus any final interest payments.
If the issuer defaults on the redemption—or on interest payments during the term of the bond—it'll be important for you to know whether your bond is secured or unsecured. A secured bond is backed by tangible collateral. That means if the issuer defaults, you have a claim to take the collateral in place of the bond. If the issuer defaults on an unsecured bond, you may be left with having to take legal action.
What are common types of bonds?
Specific bond features vary depending on the entity that issues them and how they are structured. Certain bonds may be better for certain situations, so let's look at the differences among the three main kinds: treasury, corporate and municipal.
1. Treasury bonds
The U.S. Treasury Department issues bonds to raise money to fund the federal government. They're widely regarded as the safest bonds because the government can ensure payment. As a result, however, interest rates tend to be lower than other bonds.
The agency has several offerings that differ in term length and structure:
- Treasury bonds have maturities longer than 10 years and up to 30.
- Treasury bills, or T-bills, mature in 12 months or less. Interest is collected in a lump sum at the end of the period.
- Treasury notes mature between two and 10 years of issue.
- Floating rate notes, issued in two-year terms, have a variable interest rate with payments made quarterly.
- Treasury inflation-protected securities (TIPS) have a unique structure that allows the interest payments to
adjust with inflation.
One advantage to note about federal bonds like these is you won't owe state or local income tax on the interest you receive. This is particularly valuable if you live in a state with a high income tax rate.
2. Corporate bonds
Corporations issue bonds to fund operations or borrow money for investment in things like projects, research and equipment. Most corporate bonds make interest payments every six months, and interest is taxed at both the state and federal levels.
3. Municipal bonds
A hallmark of
What are bond credit ratings?
One reason bonds tend to be a conservative and reliable investment option is that bond issuers receive credit ratings from expert investor services companies. These assessments give potential bond buyers insight into issuers' creditworthiness to make an informed decision about the potential risk.
Generally, a higher credit rating represents a safer investment. But this also may mean the interest rates on the bonds will be lower because plenty of investors will be interested in lending when there's less risk. On the flip side, bonds involving lower credit ratings generally pay higher interest to attract investors and compensate them for the increased risk.
Bonds rated "BBB-" or higher by S&P Global and Fitch Ratings or "Baa3" or higher by Moody's Investors Service are said to be investment grade and usually carry a lower risk of default. Bonds with ratings below these levels are called high-yield or "junk" bonds. They can be enticing because they pay higher interest rates, but they expose you to a greater chance of default.
Should you invest in bonds?
Bonds are often a solid choice for investors who are seeking a steady and reliable income stream or those who want to round out their other investments with a buffer against stock market volatility.
It's important to realize that bonds are not without risk. Some things to be cautious about include:
- Interest rate risk. When interest rates rise, the prices of bonds fall. This doesn't matter as much if you're holding onto your bond until maturity, but it's a factor to consider if you're planning to sell before then.
- Inflation risk. Most bonds have fixed coupon payments, which is good when you want stability. But
as inflation increases,the real value of your interest payments decreases.
- Default risk. If the issuer is unable to fulfill its financial obligations supporting the bond, you may not get the interest or might even lose your principal. As noted, this risk is smaller among higher-rated issuers, but you may want to mitigate risk by
diversifyingyour bond holdings across multiple issuers or multiple investment types.
Whether you want to know more about how to invest in bonds or are ready to explore your bond purchase options, a