What are bonds and how do they work?
Editorial staff, J.P. Morgan Wealth Management
- Companies or governments take out loans by issuing bonds, receiving money from investors and promising to pay back the loan plus additional interest over a specified time frame.
- Investors buying bonds have many options, including corporate bonds, government bonds, municipal bonds and foreign bonds.
- Investing in bonds can help diversify a portfolio, provide investors with fixed income and potentially hedge against an economic slowdown.
Bonds can be an important part of portfolios. They may provide income, diversification to a portfolio that also contains stocks and a buffer against market volatility.
We’ve compiled this guide to share the main takeaways you might need to know about bonds.
What are bonds?
A bond is a loan taken out by a company or government. Instead of going to a bank, the borrower receives money from investors who buy its bonds. In exchange for the money, the issuer promises to pay back the loan in full along with additional interest within a specified period of time. The issuer typically pays interest at predetermined intervals (usually annually or semiannually) and returns the initial amount loaned on the maturity date, or expiration date, which ends the loan.
What are the different types of bonds available to investors?
Investors have many options for which bonds to buy. Here is a breakdown of some of the most common types of bonds.
Government bonds include savings bonds, Treasury bonds and Treasury Inflation-Protected Securities (TIPS). The greatest advantage of these bonds is that they are backed by the U.S. government, which means that investors get the return of both their interest and the principal amount invested as long as they hold the bonds to maturity.
However, savings and Treasury bonds are vulnerable to inflation and changes in interest rates. In addition, they offer lower rates of return than other types of bonds due to their low-risk nature.
Corporate bonds are issued by companies that want to raise additional cash but don’t want to go to a traditional lender or dilute ownership by offering more stock to shareholders. The backing of the bond is generally the ability of the company to repay the loan, which depends on future revenues and profitability. In some cases, the company’s physical assets can be used as collateral.
Highly rated corporate bonds can help investors save for retirement, earn money to pay off college tuition or establish an emergency fund. However, corporate bonds are typically viewed as riskier investments than government bonds. To compensate for the additional risk, bonds issued by corporations often have higher interest rates.
An alternative to investing in individual corporate bonds is to invest in a bond fund or bond exchange-traded fund (ETF).
Municipal bonds are issued by government entities. There are generally two types of municipal bonds available to investors. General obligation bonds are issued to raise capital to cover expenses and are supported by the taxing power of the local government. Meanwhile, revenue bonds are issued to fund infrastructure projects and are supported by the income generated by those projects.
Municipal bonds may be attractive to risk-averse investors due to the high likelihood that the issuer will repay the debt owed. They may also be attractive for their tax advantages. While there are some exceptions, interest on municipal bonds is generally not subject to U.S. federal income tax, which may make municipal bonds a particularly attractive investment for taxpayers otherwise in the highest marginal federal income tax brackets. In addition, interest on some municipal bonds may also be exempt from state and local income tax, but in most cases this exemption only applies for bonds acquired by taxpayers that reside within the state or locality that issues the bond.
Foreign bonds are issued by a foreign country in that country’s currency. They offer investors a way to diversify internationally. However, foreign bonds, particularly those issued in emerging markets, carry additional risk, including political risk, currency risk and the risk that the country’s central banking system will become insolvent.
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What are some risks associated with bonds?
Although bonds have been historically viewed as relatively safe investments, they do come with certain risks.
Interest rate risk is the most well-known risk in the bond market. Interest rates have an inverse relationship with bond prices, so if interest rates rise, the price of bonds falls. This is because investors buy bonds at a fixed rate of return for a set period of time. If the market rate rises after the bond is purchased, the bond will trade at a discount to reflect the lower return the investor will make on the bond compared to the market rate.
Inflation risk refers to when the price levels in the economy rise, deteriorating a bond’s rate of return. This has the greatest impact on fixed bonds, which have a set interest rate from the time they are issued. For example, if a fixed-rate bond pays 3% per year, but prices in the economy have risen by 2%, then the investor is effectively earning only 1% interest.
Credit/default risk is the risk that the issuer will not be able to pay the interest and principal payments it is required to pay the investor. An investor looking into corporate bonds should consider the possibility that the company may default on its loan. Companies with greater operating income and cash flow compared to their debt are usually safer investments for bondholders.
Prepayment/call risk is the risk that a bond issue will be paid off earlier than expected, usually through a call provision that allows the issuer to repurchase and retire the security. This is bad news for the investor because call provisions typically happen only when interest rates fall after the issue date, allowing the issuer to retire the old high-rate bonds and issue new low-rate bonds to lower debt costs.
What role do bonds play in a portfolio?
Investing in bonds can help diversify a portfolio, reducing the risk of low or negative returns and protecting from volatility. In fact, a portfolio made up of 50% stocks and 50% bonds has not suffered a negative return over any five-year rolling period since 1950, according to data from J.P. Morgan Asset Management.
Moreover, bonds provide investors with fixed income because investors receive interest payments on a set schedule from the issuer. The money earned can be spent or reinvested.
Additionally, bonds can provide a potential hedge against an economic slowdown or deflation. This is because most bonds pay a fixed income that does not change. Slower economic growth can lead to deflation, which makes bond income more attractive. An economic slowdown is also typically bad for corporate profits and stock returns, making bonds an attractive alternative.
Frequently asked questions
Savings bonds are backed by the U.S. government, so investors typically get their money back and interest on top of it. However, because they are low risk, interest rates are lower and the money invested is vulnerable to inflation. But savings bonds are still considered one of the safest investments out there, and a particularly good investment for people nearing retirement age.
Essentially, yes. Buying a bond is like you issuing a loan to a government or company, and like most loans, it comes with an interest rate and a set amount of time for the borrower to pay it back.
Not generally. Government bonds pay interest every six months, as do most corporate bonds. However, some corporate bonds pay on a different schedule, typically once a quarter or once a year.
Bonds and loans are the same conceptually; for example, both loans and bonds can be ways for companies and governments to raise money. However, they have a few differences in practice. For one, loans are often taken out from private, accredited lenders – like banks – whereas bonds are purchased by individual investors on the open market. Also, most loans are not tradeable, whereas bonds can generally be traded between investors before their maturity date.
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Editorial staff, J.P. Morgan Wealth Management
