What are bonds and how do they work?
- Companies and governments can raise money by issuing bonds, receiving funds from investors and agreeing to repay the principal plus interest over a set 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 help cushion against an economic slowdown.
Bonds can be an important part of a portfolio. They may provide income, help diversify alongside stocks and add a buffer against market volatility.
Here are the main things to know about bonds.
What are bonds?
A bond is a type of loan that investors make to a company or government. Instead of borrowing from a bank, the issuer raises money from investors who buy its bonds. In return, the issuer agrees to repay the principal (the amount borrowed) and pay interest over a set period. Interest is typically paid at set intervals (often semiannually), and the principal is repaid on the bond’s maturity date.
What are the different types of bonds available to investors?
Investors have many types of bonds to choose from. Here are some of the most common.
Government bonds
Government bonds include savings bonds (such as Series EE and Series I) and Treasury securities (like Treasury Inflation-Protected Securities, or TIPS). Because they’re backed by the U.S. government, they’re generally considered low credit risk. Investors typically get the return of their principal plus earned interest as long as they hold the bonds to maturity (or redeem under the bond’s rules).
However, some savings bonds and Treasury securities can still be affected by inflation and changes in interest rates. In addition, they may offer lower rates of return than other types of bonds due to their low-risk nature.
Corporate bonds
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 may be used as part of a plan for long-term goals like retirement or education savings. 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
Municipal bonds are issued by state and local governments and other 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, municipal bond interest generally isn’t subject to U.S. federal income tax. Some bonds may also be exempt from state and local income tax, often when taxpayers reside within the issuing state or locality.
Foreign government bonds
Foreign government bonds are issued by countries outside the U.S., typically in the issuer’s local currency. They can offer international diversification, but they also carry additional risk, including currency swings, political instability and the risk that the issuer may not repay its debt.
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What are some risks associated with bonds?
Although bonds have historically been viewed as relatively safe investments, they do come with certain risks.
Interest rate risk
Interest rate risk is one of the most well-known risks 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 with a set coupon rate. If market rates rise 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
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-rate bonds, which have a set interest rate from the time they’re 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
Credit risk (also called 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
Prepayment risk (or call risk) is the risk that a bond 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?
Historically, investing in bonds has helped balance portfolios, reducing the risk of low or negative returns and protecting against volatility. For example, based on calendar-year returns, 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 can 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, some bonds can help during economic slowdowns or deflation. This is because many bonds pay a fixed interest payment 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 about bonds
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 considered low credit risk, rates may be lower than other investments, and the value of fixed-rate bonds can be eroded by inflation over time. But some savings bonds, like Series I bonds, are considered to be among the safest investments out there.
Essentially, yes. Buying a bond is like making 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. Many U.S. Treasury bonds pay interest every six months, as do many corporate bonds. Some bonds pay on a different schedule, typically once a quarter or once a year, and some (like U.S. savings bonds) accrue interest rather than paying it out.
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 made by banks or other private lenders, whereas bonds are sold to many investors in the bond market. Also, most loans are not tradeable, whereas bonds can generally be traded between investors before their maturity date.
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