What is a 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.
Income you can receive by investing in bonds or cash investments. The investment's interest rate is specified when it's issued.
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.
The sum total of your investments managed toward a specific goal.
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.
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.
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
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.
This hypothetical illustration represents a sample yield curve. It doesn't represent any particular investment.
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.
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.
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.
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.
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.
|Baa||BBB||Medium investment grade|
Below investment-grade bonds
|Ca||CC||Very poor quality|
|C||D||Imminent default or in default|
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.
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.
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.
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.
A general rise in the prices of goods and services.
A measure of how quickly and easily an investment can be sold at a fair price and converted to cash.
DOMESTIC OR INTERNATIONAL?
Bonds can also be divided based on whether their issuers are inside or outside the United States. The U.S. market makes up only a portion of the world's opportunities for bond investing.
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.
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.
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*Source: Donald G. Bennyhoff and Francis M. Kinniry Jr., 2016. Vanguard Advisor's Alpha®. Valley Forge, Pa.: The Vanguard Group.
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. The market values of government securities are not guaranteed and may fluctuate but 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.
Investments in stocks and bonds issued by non-U.S. companies are subject to risks including country/regional risk, which is the chance that political upheaval, financial troubles, or natural disasters will adversely affect the value of securities issued by companies in foreign countries or regions; and currency risk, which is the chance that the value of a foreign investment, measured in U.S. dollars, will decrease because of unfavorable changes in currency exchange rates.
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