What Is a Bond? A Beginner’s Guide To How Bonds Work

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A bond is a fixed-income investment where an investor lends money to a government, corporation or other entity. In return, the issuer agrees to pay back the principal — the original amount — at a set date while making regular interest payments along the way.

Think of it like this: You’re the lender, and the government or company is the borrower.

How Do Bonds Work?

A bond is like a loan that you give to a government or company.

A fixed interest rate will be paid to you — this is called your coupon payment. For example, a $1,000 bond with a fixed rate of 5% typically pays $50 in interest each year.

The maturity date is when the bond ends and the issuer must repay your money. So, if you buy a 15-year bond, you’ll get your $1,000 back in year 15. That $1,000 is your principal, or the original amount you invested.

Bond Example

Here’s how a 15-year bond bought at $1,000 with 5% interest breaks down:

• Face value: $1,000
• Fixed interest rate: 5%
• Maturity: 15 years 
• Annual coupon payments: 5% of $1,000 = $50 per year
• Total coupons over 15 years: $50 x 15 = $750
• Principal repayment at maturity: $1,000
• Total received: $1,750 — $750 interest + $1,000 principal

What Happens To Bond Prices When the Market Changes?

Bond Terms To Know

If you’re considering adding bonds to your portfolio, you should be familiar with key bond terms: 

• Face value: The amount you’ll receive when the bond matures.
• Coupon rate: The interest rate the bond pays — usually semiannually.
• Maturity date: The date when the bond issuer must pay back the full face value.
• Bond yield: The return an investor earns based on the purchase price and interest payments.
• Yield to maturity (YTM): The total interest rate a bond will have paid at maturity, including all interest or coupon payments and the par value.
• Duration: The duration measures how sensitive a bond’s price is to interest changes.
• Price vs. Par: The price is what the bond would trade on the  market and par is what the bond issuer would pay you back at maturity.

Types of Bonds

There are several types of bonds, each with different levels of risk, return and tax benefits. Here’s a quick overview of the most common ones.

Government Bonds

These are issued by the federal government and are considered low-risk investments.

Here are some types to know:

• U.S. Treasury bonds (T-Bonds): Long-term bonds backed by the government
• Treasury bills (T-Bills): Short-term government debt with no interest payments

Best for: Investors seeking stability and low-risk income

Corporate Bonds

Corporate bonds are bonds issued by companies to raise funds for operations, expansions or acquisitions.

Corporate bonds fall into two main categories:

• Investment-grade bonds: Issued by financially stable companies
• High-yield bonds: Junk bonds are higher risk and come with higher returns.

Best for: Investors comfortable with moderate risk and wanting higher yields

Municipal Bonds

Municipal bonds are bonds issued by state and local governments to fund public projects, like highways and schools.

Municipal bonds stand out for their tax advantages:

• Interest is often exempt from federal — and sometimes state or local — taxes.

Best for: Investors in higher tax brackets looking for tax-free income

Mortgage-Backed Securities

Mortgage-backed securities are pools of loans that banks sell to investors. 

Here are a few key points to know:

• Mortgage-backed securities often pay more than traditional bonds.
• Earnings are usually taxable at both the federal and state levels.

Best for: Investors who want a higher yield than bonds and are comfortable with housing-related risks

International Bonds

These are bonds issued by foreign governments or companies. 

Investors should keep these key points in mind:

• International bonds help investors spread risk across different markets.
• Returns can fluctuate based on exchange rate changes.

Best for: Investors who want global exposure and are comfortable with currency and geopolitical risks

Preferred Securities

A preferred security is a hybrid investment that combines features of stocks and bonds.

Here are some key takeaways:

• Steady income: Preferred securities often pay regular dividends.
• Tax advantage: Some dividends may be taxed at a lower rate.

Best for: Investors seeking income-generating investments, especially retirees who value steady dividends

Bond Ratings and Credit Quality

Bond ratings help investors understand the safety and risk of different bonds. Here’s what each rating means.

Benefits of Bonds

There are quite a few benefits of investing in bonds. Here are a few to know: 

• Stable income: Bonds provide regular interest payments, making them great for retirement planning.
• Lower risk than stocks: Bonds are less volatile than stocks, offering a safer investment option.
• Portfolio diversification: Investing in bonds helps balance risk in an investment portfolio.
• Tax advantages: Some bonds can provide tax-free interest income.

Bond Risks To Know

Even safe investments like bonds come with a few risks. Here are the main ones to watch:

• Interest rate risk: When rates rise, bond prices usually fall.
• Credit risk: If the bond issuer defaults, you could lose some or all of your investment.
• Inflation risk: If inflation grows faster than your bond’s return, your money loses buying power.
• Liquidity risk: Some bonds can be hard to sell before they mature.

Pro Tip: How To Reduce Bond Risks

Bonds are generally steady investments, but you can still protect yourself from surprises. Try these strategies:

• Stick to high-credit-rated bonds — AAA or investment grade.
• Diversify your portfolio across different bond types and issuers.
• Consider shorter-term bonds to lower interest-rate risk.

Where To Buy Bonds

If you’re ready to invest, here’s where you can buy bonds:

• From the U.S. Treasury: You can buy Treasury Bonds online at TreasuryDirect.gov.
• Through a broker: Platforms like Fidelity, Vanguard or Charles Schwab offer corporate and municipal bonds.
• Bond ETFs and mutual funds: These options are a great way to invest in multiple bonds with lower risk.

How To Buy Bonds: 4-Step Guide

Buying bonds is easier than it sounds. Follow these steps to find the right bond for your goals.

1. Pick a Goal

Decide why you want a bond:

• Are you looking for tax benefits?
• Do you want to diversify your portfolio?
• Do you need a safe investment?

Knowing your why will determine what type of bond you want. 

2. Choose a Type and Maturity Length

You can choose from treasury, municipal, corporate or international bonds. There are various stages of maturity for these bonds:

• Short-term bonds: Come in terms from one to three years and have lower risk, but also lower yield.
• Intermediate-term bonds: These bonds are from four to 10 years and can offer a balance of a good return and safety.
• Long-term bonds: Commonly are 10 years or more and can offer higher yields but more interest rate risk. 

3. Compare Prices and Yields

Brokers may add hidden fees, so it’s wise to compare prices across several bonds. Reviewing the yield to maturity will reveal the true return of the bond. 

4. Place an Order or Choose a Bond Fund

You can buy bonds from a broker or online from TreasuryDirect. 

Bonds vs. Stocks: Which Makes More Sense for You?

Bonds are known for safety — stocks for growth. Both can play a role in your portfolio, but in very different ways. Here’s how they compare side by side.

Which One Should You Choose?

• If you want stability and income, opt for bonds.
• If you want higher returns and can tolerate some risk, stocks might be better.

Final Take  

Bonds are an excellent investment for those looking for stability, predictable returns and diversification. Whether you’re saving for retirement or balancing a stock-heavy portfolio, the right mix of government, corporate and municipal bonds can help you earn steady returns and protect your future finances.

Scott Jeffries contributed to the reporting for this article.

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