Skip to main content

What is a bond? A way to get income & stability

Unlike stocks, bonds don't give you ownership rights. They represent a loan from the buyer (you) to the issuer of the bond.

POINTS TO KNOW

  • Bonds can be issued by companies or governments and generally pay a stated interest rate.
  • The market value of a bond changes over time as it becomes more or less attractive to potential buyers.
  • Bonds that are higher-quality (more likely to be paid on time) generally offer lower interest rates.
  • Bonds that have shorter maturities (length until full repayment) tend to offer lower interest rates.

Why buy bonds?

Bonds are issued by governments and corporations when they want to raise money. By buying a bond, you're giving the issuer a loan, and they agree to pay you back the face value of the loan on a specific date, and to pay you periodic interest payments along the way, usually twice a year.

Unlike stocks, bonds issued by companies give you no ownership rights. So you don't necessarily benefit from the company's growth, but you won't see as much impact when the company isn't doing as well, either—as long as it still has the resources to stay current on its loans.

Bonds, then, give you 2 potential benefits when you hold them as part of your portfolio: They give you a stream of income, and they offset some of the volatility you might see from owning stocks.

Holding bonds vs. trading bonds

If you buy a bond, you can simply collect the interest payments while waiting for the bond to reach maturity—the date the issuer has agreed to pay back the bond's face value.

However, you can also buy and sell bonds on the secondary market. After bonds are initially issued, their worth will fluctuate like a stock's would. If you're holding the bond to maturity, the fluctuations won't matter—your interest payments and face value won't change.

But if you buy and sell bonds, you'll need to keep in mind that the price you'll pay or receive is no longer the face value of the bond. The bond's susceptibility to changes in value is an important consideration when choosing your bonds.

Bond terms to know

The language of bonds can be a little confusing, and the terms that are important to know will depend on whether you're buying bonds when they're issued and holding them to maturity, or buying and selling them on the secondary market.

Coupon: This is the interest rate paid by the bond. In most cases, it won't change after the bond is issued.

Yield: This is a measure of interest that takes into account the bond's fluctuating changes in value. There are different ways to measure yield, but the simplest is the coupon of the bond divided by the current price.

Face value: This is the amount the bond is worth when it's issued, also known as "par" value. Most bonds have a face value of $1,000.

Price: This is the amount the bond would currently cost on the secondary market. Several factors play into a bond's current price, but one of the biggest is how favorable its coupon is compared with other similar bonds.

Choosing bonds

Several factors may play into your bond-buying decisions.

Maturity & duration

A bond's maturity refers to the length of time until you'll get the bond's face value back.

As with any other kind of loan—like a mortgage—changes in overall interest rates will have more of an effect on bonds with longer maturities.

For example, if current interest rates are 2% lower than your rate on a mortgage on which you have 3 years left to pay, it's going to matter much less than it would for someone who has 25 years of mortgage payments left.

Because bonds with longer maturities have a greater level of risk due to changes in interest rates, they generally offer higher yields so they're more attractive to potential buyers. The relationship between maturity and yields is called the yield curve.

In a normal yield curve, shorter maturities = lower yields

A chart showing that bonds with longer maturities usually offer increasingly higher yields

This hypothetical illustration represents a sample yield curve. It doesn't represent any particular investment.

Take a closer look... In certain conditions, this relationship can flip, a situation known as an "inverted" yield curve.

Read a transcript

Bond duration, like maturity, is measured in years. It's the outcome of a complex calculation that includes the bond's present value, yield, coupon, and other features. It's the best way to assess a bond's sensitivity to interest rate changes—bonds with longer durations are more sensitive.

Take a closer look ... What's the difference between duration and maturity? See why duration tells you more about a bond's risk.

Read a transcript

Quality

Unlike with stocks, there are organizations that rate the quality of each bond by assigning a credit rating, so you know how likely it is that you'll get your expected payments.

Just as with a car loan or a mortgage, the better the borrower's credit rating, the lower the yield.

If the rating is low—"below investment grade"—the bond may have a high yield but it will also have a risk level more like a stock. On the other hand, if the bond's rating is very high, you can be relatively certain you'll receive the promised payments.

The 2 best-known agencies that rate bonds are Standard & Poor's (S&P) and Moody's Investors Service. They have similar ratings systems, which are based on the issuer's current financial and credit histories.

Types of bonds

Companies can issue bonds, but most bonds are issued by governments. Because governments are generally stable and can raise taxes if needed to cover debt payments, these bonds are typically higher-quality, although there are exceptions.

U.S. Treasuries

These are considered the safest possible bond investments.

You'll have to pay federal income tax on interest from these bonds, but the interest is generally exempt from state tax. Because they're so safe, yields are generally the lowest available, and payments may not keep pace with inflation. Treasuries are extremely liquid.

Certain types of Treasuries have specific characteristics:

  • Treasury bills have maturities of 1 year or less. Unlike most other bonds, these securities don't pay interest. Instead, they're issued at a "discount"—you pay less than face value when you buy it but get the full face value back when the bond reaches its maturity date.
  • Treasury notes have maturities between 2 years and 10 years.
  • Treasury bonds have maturities of more than 10 years—most commonly, 30 years.
  • Treasury Inflation-Protected Securities (TIPS) have a return that fluctuates with inflation.

Take a closer look ... Do you need income that fluctuates with inflation? Learn more about our TIPS funds.

  • Separate Trading of Registered Interest and Principal of Securities (STRIPS) are essentially Treasuries that have had their coupon payments "stripped" away, meaning that the coupon and face value portions of the bond are traded separately.
  • Floating rate notes have a coupon that moves up and down based on the coupon offered by recently auctioned Treasury bills.

Government agency bonds

Some agencies of the U.S. government can issue bonds as well—including housing-related agencies like the Government National Mortgage Association (GNMA or Ginnie Mae). Most agency bonds are taxable at the federal and state level.

These bonds are typically high-quality and very liquid, although yields may not keep pace with inflation. Some agency bonds are fully backed by the U.S. government, making them almost as safe as Treasuries.

Because mortgages can be refinanced, bonds that are backed by agencies like GNMA are especially susceptible to changes in interest rates. The families holding these mortgages may refinance (and pay off the original loans) either faster or slower than average depending on which is more advantageous.

If interest rates rise, fewer people will refinance and you (or the fund you're investing in) will have less money coming in that can be reinvested at the higher rate. If interest rates fall, refinancing will accelerate and you'll be forced to reinvest the money at a lower rate.

Go in-depth ... Read our white paper examining the benefits and drawbacks of investing in mortgage-backed securities (MBS).

Municipal bonds

These bonds (also called "munis" or "muni bonds") are issued by states and other municipalities. They're generally safe because the issuer has the ability to raise money through taxes—but they're not as safe as U.S. government bonds, and it is possible for the issuer to default.

Interest from these bonds is free from federal income tax, as well as state tax in the state in which it's issued. Because of the favorable tax treatment, yields are generally lower than those of bonds that are federally taxable.

Corporate bonds

These bonds are issued by companies, and their credit risk ranges over the whole spectrum. Interest from these bonds is taxable at both the federal and state levels. Because these bonds aren't quite as safe as government bonds, their yields are generally higher.

High-yield bonds ("junk bonds") are a type of corporate bond with low credit ratings.

What's next?

You can research and choose bonds individually, but we strongly recommend that most of your bond portfolio be made up of mutual funds or ETFs (exchange-traded funds).


WE'RE HERE FOR YOU

If you'd like some help with your investing decisions, here are a few ways you can get the answers you need.

Get a portfolio recommendation. It's fast, it's free, and in a few minutes we'll recommend a handful of mutual funds or ETFs you can buy today.

Partner with a Vanguard advisor. If you'd like a professional to manage your portfolio for you, we can do that. Research shows that an advisor who provides professional financial planning, coaching, and portfolio management services can add meaningful value compared to the average investor experience.*


Get complete portfolio management

We can custom-develop and implement your financial plan, giving you greater confidence that you're doing all you can to reach your goals.

Saving for retirement or college?

See guidance that can help you make a plan, solidify your strategy, and choose your investments.

Already know what you want?

From mutual funds and ETFs to stocks and bonds, find all the investments you're looking for, all in one place.

REFERENCE CONTENT

Layer opened.

Interest

Income you can receive by investing in bonds or cash investments. The investment's interest rate is specified when it's issued.

Layer opened.

Stock

Usually refers to common stock, which is an investment that represents part ownership in a corporation. Each share of stock is a proportional stake in the corporation's assets and profits.

Layer opened.

Portfolio

The sum total of your investments managed toward a specific goal.

Layer opened.

Secondary market

A place where investors buy and sell to each other (rather than buying directly from a security's issuer). Most stock and bond trading happens on the secondary market.

Layer opened.

Risk

Usually refers to investment risk, which is a measure of how likely it is that you could lose money in an investment. However, there are other types of risk when it comes to investing.

Layer opened.

In a normal yield curve, shorter maturities = lower yields

This graph shows a sample "normal" yield curve. Bonds usually offer increasingly higher yields as their maturities get longer.

Layer opened.

The yield curve: What it is and what it means

Layer opened.

The yield curve: What it is and what it means

Normal

This is how a yield curve is built. Along the bottom it shows bond maturities. On the vertical axis you see interest rates, or yields. Now, let's say that a two-year bond is offering a yield of 2.5%, and a five-year bond is offering 2.7%, and a ten-year bond offers 3.3%, and so on. When you connect all these dots, what you get is the yield curve. This is a typical yield curve. What makes it typical isn't the yield figures. Instead, it's the shape of the curve. A typical yield curve can start anywhere, but it will generally have a shape something like this, with a gradual rise from left to right. That's because people who invest at shorter maturities aren't taking on as much risk as others. So, they normally don't get paid as much. And that's true along the line.

Flat

This is a flat yield curve. Of course, the term "flat curve" doesn't seem to make much sense, but that's the way economists talk about it. When the yield curve looks like this, with short-term rates about the same as long-term rates, it's generally a signal that there's a lot of uncertainty about the outlook for the economy, interest rates, and inflation. In fact, this is the yield curve on July 1, 2007, just a couple of months before the financial crisis began.

Inverted

This is an inverted yield curve with short-term interest rates higher than long-term rates. An inverted curve shows that the bond market is under stress because it essentially means that investors are being paid more for taking less risk. Inverted curves are not usually very dramatic looking, but they can be. For example, here is the yield curve from September 14, 1981.

What does this mean to you?

The short answer is not much in terms of your own investing. It can help provide context for interest rates, and it's a useful tool for economists and portfolio managers. But the yield curve, no matter what shape it is, is not a critical consideration for long-term investment planning. If you hold a broadly diversified bond portfolio, you'll probably have exposure to all parts of the yield curve.


The hypothetical illustrations do not represent the return on any particular investment. All investing is subject to risk, including the possible loss of principal.

Layer opened.

Volatility

The degree to which the value of an investment (or an entire market) fluctuates. The greater the volatility, the greater the difference between the investment's (or market's) high and low prices and the faster those fluctuations occur.

Layer opened.

What is bond duration?

Layer opened.

What is bond duration?

Liz Tammaro: And from Jim in Washington, "So what is the difference between duration and average maturity? Which is a better measure of volatility to interest rate changes?" Ron?

Ron Reardon: That's a great question. We're throwing around these two terms maturities and duration. And they are different. I won't go into the mathematics of it. There are different calculations. But the duration of a bond fund includes not just the maturity when you get your principal back, but it also takes into account when you get the cash flows back, right. So it takes into account the couponing of it as well. And that measure is actually the better measure of volatility or sensitivity—

Liz Tammaro: Duration.

Ron Reardon: Exactly right. So and that's available on all our funds. So a longer-duration fund, or a longer-duration bond, will have more sensitivity to rates, a shorter-duration bond or bond fund will have less sensitivity to rates.

Liz Tammaro: Okay.

Chuck Riley: And when I talk to clients and they ask me about duration and how do they think about that in terms of their own portfolios, one thing that I talk to them about is that you know so the duration is a good way to measure the interest rate risk in terms of how much a bond fund's value is going to fluctuate when interest rates go up 1%. But the age-old rule being that if they go up 1% and it's a duration of five years the fund is going to fall 5%.

But the thing to remember is that that duration I think is most helpful for investors in order to be able to compare that, that particular fund, or that portfolio, to other products to determine how much additional risk. It's not necessarily that it's going to fall 5%, because interest rates are dynamic, they change, they move, values of bonds move. But really using that duration measure as a way to chart the—or come up with the risk of that fund relative to other funds I think is the most helpful.

Liz Tammaro: So as you're building your bond allocation and your bond portfolio you would be looking at a measure like duration to figure out which fund may be most appropriate for you and in your portfolio.

Chuck Riley: Right. And when we build portfolios, when I build portfolios for my clients, we focus on intermediate-term bonds, we find that that's the sweet spot. They have a duration of about five years, five to five and a half years. And we really feel that that's the sweet spot of bonds because you're getting almost all the yield, not all the yield, but you're getting a good portion of the yield that you would find in a long-term bond fund. But you're not taking as much risk and conversely you're getting a lot more income than you are from a short-term fund, but again you're not taking all that much more risk. So it's really finding that balance. An intermediate-term is where we tend to think the sweet spot is.

Liz Tammaro: And I think this is a related question that's coming to us from Bob: "I have read that if your time horizon is longer than the bond fund, or the bond's duration, you benefit in a rising-rate environment. Can you please explain the math behind this statement?" What do you think about this one?

Ron Reardon: Let's stay away from the math. Alright.

Chuck Riley: Thank you, Ron.

Liz Tammaro: We'll talk conceptually, how about that?

Ron Reardon: Well, yes, but if you think about it, right, if you have a five-year investment horizon and as opposed to buying a five-year bond fund you buy a three-year bond fund. The idea is that you get that money back sooner, you can then reinvest that money at the higher rate. So I think that's where the rule of thumb comes from. And I think that's fair. The thing to keep in mind though is that again we mentioned earlier that future paths of interest rates are already priced into the price of bonds today. So what really is important not so much that you invest at a higher rate in three years' time if you buy that three-year bond fund, but that you invest in a rate higher than what the expectation was, right, at the time of your original investment. And again this is just a difficult thing for most investors to really kind of come to a conclusion on.


All investing is subject to risk, including the possible loss of the money you invest. Diversification does not ensure a profit or protect against a loss.

Bond funds are subject to interest rate risk, which is the chance bond prices overall will decline because of rising interest rates, and credit risk, which is the chance a bond issuer will fail to pay interest and principal in a timely manner or that negative perceptions of the issuer's ability to make such payments will cause the price of that bond to decline.

For more information about Vanguard funds, visit vanguard.com, or call 877-662-7447, to obtain a prospectus. Investment objectives, risks, charges, expenses, and other important information about a fund are contained in the prospectus; read and consider it carefully before investing.

This webcast is for educational purposes only. We recommend that you consult a tax or financial advisor about your individual situation.

Advisory services are provided by Vanguard Advisers Inc. (VAI), a registered investment advisor.

© 2015 The Vanguard Group, Inc. All rights reserved. Vanguard Marketing Corporation, Distributor.

Layer opened.

Guide to bond credit quality & ratings

A bond's credit quality is usually determined by independent bond rating agencies, such as Moody's Investors Service, Inc., and Standard & Poor's Corporation (S&P).

These agencies classify bonds into 2 basic categories—investment-grade and below-investment-grade—and provide detailed ratings within each.

Investment-grade bonds


MOODY'S

Aaa

S&P

AAA

CREDIT RISK

Highest quality


MOODY'S

Aa

S&P

AA

CREDIT RISK

High quality


MOODY'S

A

S&P

A

CREDIT RISK

Strong quality


MOODY'S

Baa

S&P

BBB

CREDIT RISK

Medium investment grade

Below-investment-grade bonds


MOODY'S

Ba

S&P

BB

CREDIT RISK

Low grade


MOODY'S

B

S&P

B

CREDIT RISK

Very speculative


MOODY'S

Caa

S&P

CCC

CREDIT RISK

Substantial risk


MOODY'S

Ca

S&P

CC

CREDIT RISK

Very poor quality


MOODY'S

C

S&P

D

CREDIT RISK

Imminent default or in default

Layer opened.

Inflation

A general rise in the prices of goods and services.

Layer opened.

Liquidity

A measure of how quickly and easily an investment can be sold at a fair price and converted to cash.

Layer opened.

Municipal bond basics

Layer opened.

Municipal bond basics

Rebecca Katz: All right, so our first question is actually from Kathy in Urbana, Illinois, and Kathy says, "My question is really a request. Would you please begin your discussion with an overview of muni bonds for those of us who have zero experience with them?" So, Daniel I'm going to throw that one to you.

Daniel Wallick: Sure. So, you can think of them as a contract between a local or state government and people that lend them money. And what state and local governments are trying to do typically is fund capital projects, and what we mean by capital projects are projects that take a lot of money, a lot of capital. And so that could be a road, or that could be a school, or that could be a hospital, or that could be an electric system, or that could be a sewer. It could be any one of a number of things that just takes a lot of money. So what governments do, is they go out and borrow that money, pay for it up front to fund the project, and then repay that over a long period of time.

Rebecca Katz: Okay, and I did mention that there's some tax advantages to munis. Want to touch on that quickly?

Daniel Wallick: Sure and so municipal bonds in particular since they affect state and local governments, they tend to have a tax advantage. So they're not subject to federal, state, or local taxes depending on the jurisdiction. And so there's this difference you'll see in the yields that accommodates for that difference in the tax impact.


All investing is subject to risk, including the possible loss of the money you invest.

For more information about Vanguard funds, visit vanguard.com or call 877-662-7447 to obtain a prospectus. Investment objectives, risks, charges, expenses, and other important information about a fund are contained in the prospectus; read and consider it carefully before investing.

Although the income from a municipal bond fund is exempt from federal tax, you may owe taxes on any capital gains realized through the fund's trading or through your own redemption of shares. For some investors, a portion of the fund's income may be subject to state and local taxes, as well as to the federal Alternative Minimum Tax.

This webcast is for educational purposes only. We recommend that you consult a financial or tax advisor about your individual situation.

© 2014 The Vanguard Group, Inc. All rights reserved. Vanguard Marketing Corporation, Distributor.

Layer opened.

Municipal bonds and your portfolio

Layer opened.

Municipal bonds and your portfolio

Rebecca Katz: Okay, great. Our next question is from—oh, it's a good follow-on question, from Steve in Columbus, Ohio. Thanks, Steve. "What is the role of munis in the taxable portion of a diversified portfolio? How do they fit into your overall bond allocation?" So now we're getting more specific. You know you need bonds for diversification and to minimize volatility. How much muni versus taxable?

Daniel Wallick: Right. A lot of this is going to drive off of a couple things. One, what's your risk tolerance. We talked earlier about the different types of bonds. Let's just talk about the three big buckets. You can have Treasuries, which are guaranteed by the U.S. government. You can have municipals, which are guaranteed by a state or local government, or you can have corporate bonds, which are guaranteed by some private company.

The risk level is: the U.S. bonds are most secure, right, U.S. Treasuries are the most secure; munis are next; and then corporates are there. So where are you in terms of that comfort level of how much risk you're willing to take? It's really the first question to ask.

The second one is, "What's the yield on munis, what's your tax rate, and how does that relate to the other options you have, and is it a valuable investment based on that?"

Rebecca Katz: Right. I believe we have a chart we can show you on how to calculate what we call the "taxable-equivalent yield," correct?

Chris Alwine: Yeah. If we could bring up that slide to go through it. Now, it looks a little busy up there, but if you look at the top formula, the tax-equivalent yield equals your muni yield divided by one minus your tax rate. Your tax rate, though, is the combined tax rate. It would be your top marginal federal tax rate, as well as state, and then also the Affordable Care Act. This is a new tax that was instituted in 2013 for investment earnings. Now, munis are exempt from that.

What we did here is we took an example. A 10-year A-rated muni today yields about 2.80%. Someone in the top tax bracket would be paying 0.434% tax rate, so one minus that percentage. We divide that out, and we get 4.95%. Now it's important to keep in mind when we're looking at tax-equivalent yields, we need to compare them to a similar alternative in taxable space. Daniel brought up the different risk spectrums, so if we were to calculate the tax-equivalent yield of a high-yield muni to a Treasury security, that would not be a fair comparison. One has a lot more risk than the other. So A-rated to A-rated, AA to A, those types of comparisons make more sense.

Now for the mathematically inclined, I will give a differing variation for that. It's not up on the screen, but your break-even tax rate would be one minus the muni yield divided by the taxable yield. For those who want to manipulate the formula, who prefer to do algebra, it's out there to give it a try. But one minus the muni yield divided by the taxable yield gives you your break-even tax rate.

Rebecca Katz: Okay, great. Well, we actually have a good follow-up question around break-evens, actually. This is from Timothy in New York, and he says, "Analyzing break-evens between taxable and tax-exempt bonds, does it make sense sometimes for someone not in the highest marginal tax rate to invest in munis?" Daniel, why don't I throw that one to you?

Daniel Wallick: It can. One is, "What's the absolute level of muni yields?" So, where are they actually trading? The other is, "What's your tax rate, your tax level?" Again, going through the math that Chris just articulated, you can figure out if it's a benefit relative to the other options that are out there.

I will go back and just reiterate what Chris said. It's really important to be comparing apples to apples, here. There may be something that looks attractive on a yield basis, but what's underlying that that we don't recognize is there's actually more risk associated with that. That may be a perfectly rational decision to make, but you want to make that consciously, not subconsciously.


All investing is subject to risk, including the possible loss of the money you invest. Investments in bonds are subject to interest rate, credit, and inflation risk. Diversification does not ensure a profit or protect against a loss.

For more information about Vanguard funds, visit vanguard.com or call 877-662-7447 to obtain a prospectus. Investment objectives, risks, charges, expenses, and other important information about a fund are contained in the prospectus; read and consider it carefully before investing.

Although the income from a municipal bond fund is exempt from federal tax, you may owe taxes on any capital gains realized through the fund's trading or through your own redemption of shares. For some investors, a portion of the fund's income may be subject to state and local taxes, as well as to the federal Alternative Minimum Tax.

This webcast is for educational purposes only. We recommend that you consult a financial or tax advisor about your individual situation.

© 2014 The Vanguard Group, Inc. All rights reserved. Vanguard Marketing Corporation, Distributor.

Layer opened.

Mutual fund

A type of investment that pools shareholder money and invests it in a variety of securities. Each investor owns shares of the fund and can buy or sell these shares at any time. Mutual funds are typically more diversified, low-cost, and convenient than investing in individual securities, and they're professionally managed.

Layer opened.

ETF (exchange-traded fund)

A type of investment with characteristics of both mutual funds and individual stocks. ETFs are professionally managed and typically diversified, like mutual funds, but they can be bought and sold at any point during the trading day using straightforward or sophisticated strategies.