What is a bond? This guide explains how bonds work, their types, and why they're a key part of investment portfolios. Learn with Vanguard.
What is a bond?
Points to know
- Bonds can be issued by companies or governments, and generally pay investors a stated interest rate.
- The market value of a bond changes over time as it becomes more or less attractive to potential buyers.
- Higher-quality bonds (those that are more likely to be paid on time) generally offer lower interest rates.
- Bonds with shorter maturities (length until full repayment) tend to offer lower interest rates.
Understanding bonds
When governments or corporations want to borrow money, they can issue bonds, which are securities that usually pay investors a fixed interest rate. Bonds are often referred to as fixed income securities because they typically make regular interest payments until they reach the maturity date.
Bonds differ from stocks in many ways, but both can play an important role in your investment portfolio. While stocks represent part ownership in a company, bonds represent a loan with the promise to repay any borrowed money, along with a set amount of interest. In some cases, such as with Treasury bills, the bond issuer might compensate investors by selling the bond at a discount and paying the full face value at maturity.
Investors use stocks and bonds to balance risk and reward within an investment portfolio. When you want a safer, more predictable investment, bonds tend to be the better option. If you're looking for potentially higher returns and have a higher risk tolerance or a longer investment time horizon, you might choose to buy stocks.
How do bonds work?
A bond works similarly to a loan, with the investor acting as the lender and the issuer acting as the borrower. In exchange for a loan today, the lender agrees to pay the borrower back in the future, in addition to making interest payments (or selling the bond below its face value and paying the investor the full face value at maturity).
Most bonds offer a fixed interest rate—usually paid twice per year—and return the full principal amount on the maturity date. For example, let's say you purchase a 2-year, $1,000 bond with a 5% fixed interest rate that's paid semiannually. You'll earn $25 in interest every 6 months. When the bond matures in 2 years, you'll have earned a total of $100 in interest, and your initial $1,000 will be returned to you.
In addition to individual bonds, there are also bond funds, which contain hundreds or thousands of individual bonds in a single security. Unlike individual bonds, bond funds generally don't have a set maturity date when the principal is returned. Instead, they pool money from many investors to buy a diversified mix of bonds, and the fund manager buys new bonds when the older bonds mature. Because of this structure, investors in bond funds typically receive income through regular distributions, which may occur monthly, quarterly, or on another schedule depending on the fund. While bond funds offer diversification and professional management, their value can fluctuate daily, and investors may not recover their initial investment if they sell shares when prices are down.
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. The interest rate paid by the bond. In most cases, it won't change after the bond is issued.
Yield. 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 option is to divide the bond's coupon rate by its current price (known as the "current yield").
Face value. 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. The current cost to buy the bond on the secondary market. Several factors affect a bond's current price, but one of the most important is its coupon rate relative to other similar bonds.
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Types of bonds
Some companies will issue bonds, but most bonds are issued by governments or government agencies. The main types of bonds are U.S. Treasuries, government agency bonds, municipal bonds, and corporate bonds.
U.S. Treasuries
U.S. Treasuries 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 and local taxes. Because they're so safe, yields are generally the lowest available, and payments may not keep pace with inflation. Treasuries are also extremely liquid.
U.S. Treasuries come in a few different options with varying maturity terms and features:
- Treasury bills have maturities of one 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.
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- Separate Trading of Registered Interest and Principal of Securities (STRIPS) are essentially Treasuries that have had their coupon payments "stripped" away, meaning the coupon and face value portions of the bond are traded separately. STRIPS are sold at a price below the face value but pay investors the full face value at maturity.
- Treasury 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 also issue bonds, 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 people holding these mortgages may refinance (and pay off the original loans) either faster or slower than the 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.
Municipal bonds
Municipal bonds (also known as "muni bonds" or "munis") are issued by states and other municipalities. They're generally safe because the issuer can 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 municipal bonds is typically 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
Corporate bonds are issued by companies, and their credit risk can span the entire spectrum. Interest from these bonds is taxable at both the federal and state levels. Because corporate 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 issued by companies with low credit ratings. Since investments in these bonds come with a greater risk of default, investors expect higher yields to compensate for the increased risk.
Benefits of bonds
Owning bonds can help you strengthen your investment portfolio with several benefits, including:
- Diversification. When you invest in bonds, you can diversify your portfolio by spreading risk across different asset types.
- Predictable payments. Most bonds offer predictable interest payments, which can help stabilize your portfolio and provide you with regular income.
- Less volatility. Bonds tend to be much less volatile than stocks and come with lower overall risks. With their lower risk profile, bonds can act as a buffer against the effects of a volatile stock market.
- Potential tax advantages. Municipal bonds are generally tax-free at the federal level, while U.S. Treasuries are typically exempt from state and local taxes.
- Returns that can outpace inflation. Though bonds may not offer the same returns as stocks, they can help hedge against the effects of inflation.
Learn more about the bond market.
Understanding bond yields and interest rates
Bond prices and interest rates have an inverse relationship, meaning they tend to move in the opposite direction. When interest rates rise, bond prices tend to fall. That's because investors can buy new bonds with yields that reflect the new, higher interest rate, making older bonds less attractive and causing their prices to decline. If interest rates decline, the yield on new bonds will be lower, making older bonds—and their comparatively higher yields—more attractive to investors.
Holding bonds versus 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, since 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.
Choosing bonds
Several factors may play into your bond-buying decisions, and it's important to consider the risks of owning bonds, along with your financial goals and overall risk tolerance.
Risks of owning bonds
- Default risk. If an issuer defaults, it might fail to make scheduled interest payments or pay back your principal.
- Interest rate risk. If interest rates rise, it could cause the prices of bonds you already own to decline.
- Call risk. If you own callable bonds (meaning the issuer can redeem the bond before maturity), and the issuer decides to call the bond early, you could miss out on future interest payments.
- Reinvestment risk. If you plan to reinvest any interest earned or principal returned, you might receive a lower yield on the new investment if rates have declined.
- Inflation risk. If inflation is high, it could outpace the fixed interest rate paid on your bond, reducing your purchasing power.
- Liquidity risk. If you own bonds that don't trade frequently, it might be more difficult to access your money.
Maturity and 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 existing mortgage rate and you have 3 years left on the loan, it's going to matter much less for you than it would for someone who has 25 years of payments remaining on theirs.
Bonds with longer maturities are more sensitive to changes in interest rates, increasing their level of risk. As a result, these bonds tend to offer higher yields to make them 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
This hypothetical illustration represents a sample yield curve. It doesn't represent any particular investment.
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.
How are bonds rated?
Bonds are rated by independent rating agencies—such as Standard & Poor's, Moody's, and Fitch Ratings—that analyze a bond issuer's creditworthiness and assign a rating. These agencies consider an issuer's financial situation, credit history, and other factors to determine if the issuer is likely to meet its financial obligations, including repaying its bondholders.
Credit ratings are assigned on a scale ranging from AAA (the best possible rating) to C or D (the lowest possible ratings). When a bond issuer receives a strong credit rating (BBB− or higher for S&P and Fitch, or Baa3 or higher for Moody's), its bonds are referred to as "investment grade," indicating that a default is unlikely. Since bonds from issuers with higher credit ratings carry less risk, they tend to pay a lower yield than bonds rated "below investment grade."
How to invest in bonds
Most bonds are purchased through brokers and other financial institutions, but you may be able to buy some bonds directly from the issuer (such as U.S. savings bonds). As an investor, you can research and buy individual bonds, or purchase a basket of different bonds through fixed income mutual funds or ETFs (exchange-traded funds).
Since individual bonds come with greater risks, higher transaction costs, and less liquidity, many investors choose to buy shares in professionally managed bond funds instead of buying individual bonds. A bond fund allows you to purchase hundreds of different bonds in a single security, helping diversify your investment and reduce costs.
Read more about the benefits of bonds
Read more about the benefits of bonds
Frequently asked questions about bonds
Though all bonds are subject to risk, U.S. Treasuries are widely considered the safest type of bond because they have a very low risk of default.
To determine if a bond is a good investment, it's important to consider your financial goals, risk tolerance, and time horizon, as well as the bond's yield and maturity, the issuer's credit rating, and whether the interest is tax-exempt. If you're unsure about which bonds to invest in, consider talking to a financial advisor.
When a bond issuer defaults, it means it has failed to make an interest or principal payment to its bondholders. The specific outcomes of a default can vary depending on the terms of the bond agreement, the jurisdiction, and the overall financial health of the issuer.
Bonds are loans made to governments, government agencies, or corporations in exchange for a set interest rate payment; stocks represent part ownership in a corporation. Though bonds and stocks are both common investment types, bonds tend to be safer than stocks but usually come with lower returns.
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.
Investments in bonds are subject to interest rate, credit, and inflation risk.
While U.S. Treasury or government agency securities provide substantial protection against credit risk, they do not protect investors against price changes due to changing interest rates. While the market values of government securities are not guaranteed and may fluctuate, these securities are guaranteed as to the timely payment of principal and interest.
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.
High-yield bonds generally have medium- and lower-range credit quality ratings and are therefore subject to a higher level of credit risk than bonds with higher credit quality ratings.