What is a bond?

Bonds are relatively safe investments because the issuer is legally obligated to make the interest and principal payments. As they generate regular payments, bonds are often referred to as fixed income investments. Bonds can be a good way to diversify your investment portfolio and to generate income. They are generally dependable, but not perfectly safe. Understanding the risks can help you make the best decision relative to your financial goals.

How does a bond work?

Years ago, bonds were issued on paper and had two parts: the bond and the coupon. The coupons were attached to the bond the same way that someone selling a bicycle might make a sign and then cut tabs on the bottom that list contact information. When interest payments were due, the bondholder would cut off the coupon and take it to the bank to cash it in. On the maturity date, the bond holder would take the bond itself to the bank to receive the principal.

A zero-coupon bond, also called a discount bond, is a bond without coupons. This bond is sold at a deep discount to its par value. Investors receive the full face value of the bond when it matures, and the difference in price reflects the interest to be earned. 

Bonds are almost always issued electronically, but the terminology from the paper days is still used. You can buy most bonds from a brokerage firm or through a bond mutual fund or ETF. U.S. government bonds may be purchased directly through the Treasury Department. 

Types of bonds

Bonds are classified into two broad categories based on the type of issuer. If it’s a business, then the bond is a corporate bond. If the issuer is a government entity, then the bond is a government bond. That part’s simple.  

Those two categories contain multiple sub-categories to address the different needs of borrowers and investors. 

Primary types of corporate bonds:

• Investment grade bonds: These are bonds issued by corporations. They are riskier than Treasury bonds, as corporations are more likely to default on their debt.

• High-yield bonds: These are bonds that offer a higher interest rate than other types of bonds. They are also known as “junk bonds” because they are riskier investments.

Primary types of government bonds:

• Treasury bonds: These are bonds issued by the U.S. government. They are the safest type of bond, as the U.S. government has never defaulted on its debt.

• Savings bonds: The U.S. government offers small-denomination bonds to help people save money while also raising funds for the government. These include I bonds, which are indexed for inflation. 

• Agency bonds: Agency bonds are issued by agencies affiliated with the U.S. government such as Ginnie Mae (the Government National Mortgage Association) or Freddie Mac (the Federal Home Loan Mortgage Corporation).

• Municipal bonds: Often called munis, these bonds are issued by cities, counties, and states to fund their activities. The interest income is exempt from federal income tax, which makes them popular with people in high tax brackets. 

Are bonds a good investment?

Because most bonds pay regular interest and are safer than common stock, bonds are a standard component of a diversified portfolio. Adding some fixed-income securities can cushion your portfolio during times when the stock market is volatile. People looking for regular income, such as retirees, often have bond investments because they are looking for predictability. 

As with any investment, prospective bond buyers should do research to ensure that this is the right move for them at the right time. Bond prices change with interest rates, so they can go up or down in value. With so many bond mutual funds and exchange-traded funds on the market, the choices can be overwhelming—but there’s a good likelihood of finding a suitable investment with just a little bit of work.

Alternatives to bond investing

A traditional bond investment offers regular income andrelatively low volatility. There are a few alternatives that offer similar characteristics: CDs and dividend-paying stocks. Bank CDs usually have lower interest rates, but not always, and they generally have a shorter time to maturity. Because they are federally insured, they are a safer investment.  

Dividend-paying stocks offer regular income. Companies generally don’t start paying dividends until the management is confident that the business is stable enough to generate the necessary cash to pay them. That’s why the shares in these companies are usually less volatile than shares in other companies, although they are still more volatile than most bonds.

Bond FAQs 

What is a bond coupon?

A bond coupon is a fixed amount of interest paid by the bond issuer to the bond holder. The word derives from the original design of bonds as pieces of paper with coupons attached, that investors took to their bank when it was time to receive their payment.

What is the face value of a bond?

The face value of a bond is the principal amount. This is usually, but not always, $1000. It is also known as the par value, and it may be very different from the current market price. 

What is a bond yield?

A bond yield is the rate of return based on the current rate of interest in the market. It is usually different from the coupon rate, which was set at the time that the bond was issued.

How do bond prices react to market interest rates?

When interest rates go up, bond prices go down. When rates go down, bond prices go up. If you own a bond with an annual interest payment of $40 and go to sell it, and buyers can buy bonds that pay $50 a year, anyone looking at your bond will offer less than the face value. On the other hand, if you own a bond with an annual interest payment of $40 and new bonds in the market pay $10, your bond will be a lot more interesting to buyers.  

What if I need to get out early?

Bonds can be sold before maturity. You’ll need to go through a brokerage firm. The price you receive will be based on the current market value and may be more or less than what you paid for the bond. Investors who are concerned with liquidity may be more interested in a bond fund. 

How can I buy a bond? 

Most types of bonds are purchased through a broker. (Note that brokers usually charge fees.) If you’re buying this type of bond, you’ll be getting it from another investor. The exceptions are Treasury bonds and savings bonds, which can be purchased from the government via the TreasuryDirect.gov website. The government does not charge any broker fees for this service.

Editorial Disclosure: All articles are prepared by editorial staff and contributors. Opinions expressed therein are solely those of the editorial team and have not been reviewed or approved by any advertiser. The information, including rates and fees, presented in this article is accurate as of the date of the publish. Check the lender’s website for the most current information.

This article was originally published on SFGate.com and reviewed by Lauren Williamson, who serves as Financial and Home Services Editor for the Hearst E-Commerce team. Email her at [email protected].