What Is a Bond?
Bonds are a type of investment asset that investors can buy to earn a fixed rate of return. Because bonds generate a fixed return, the gains tend to be less than investing in stocks. However, the return is guaranteed, unlike with regular stocks.
Investors tend to buy bonds because they want a safer investment asset compared with the stock market. Most investment portfolios include some percentage in bonds to offset the risk of other assets. However, bonds are not entirely risk-free, and investors should know the advantages, disadvantages and risks of bonds before investing.
Buying bonds is easy. You can purchase bonds directly from an issuer or through a broker.
Types of Bonds
There are many options when it comes to bonds, so investors have plenty of choices. The characteristics of a bond include the issuer, time until maturity, interest rate and risk. Like most assets, the safer the investment is, the lower the return will be. Bonds are no exception to this rule.
U.S. Treasury Bonds
Investors consider Treasury bonds to be one of the safest assets because the U.S. government backs them. The federal government offers several options, depending on your investment horizon. Here are some of the most common.
|Common U.S. Treasury Securities|
|Treasury Bills||Mature anywhere from four weeks to a year|
|Treasury Notes||Mature between two and 10 years|
|Treasury Bonds||Mature in 30 years|
All of these options are safe investment options but generate lower profits compared with other assets.
Companies issue corporate bonds to investors when they seek to raise additional funding, like when they want to build a new factory, for example. Corporate bonds are riskier than Treasury bonds and are only as good as the company’s financial strength. These bonds pay a fixed rate until the maturity date. It’s important to know that owning a corporate bond does not give the investor any ownership or voting rights like owning its stock would.
High-risk, high-return options called “junk bonds” are available for investors who want a high-yield corporate bond. The U.S. Securities and Exchange Commission considers them at a higher risk of default because the issuing company might be highly leveraged or be experiencing financial difficulties.
Other governments issue municipal bonds to fund major projects. Issuers include states, cities and counties. These bonds come with a slightly higher risk than Treasury bonds but also generate more profits in return. Municipal bonds, known as “munis,” can often generate federal tax-free profits. You may also not have to pay state or local taxes on the gains depending on where you live.
Did You Know?
You can elect to receive your 2020 tax refund to purchase paper savings bonds from the U.S. Treasury.
How Do Bonds Work?
Bonds are essentially a loan to the issuer from the investor. At the maturity date, the issuer, or borrower, will pay the bond back. Until that time, the issuer will pay interest to the bondholder. The maturity date, interest rate and payment terms are all agreed upon in advance.
For example, a $10,000 bond issued with a 5% interest, or coupon, rate and a 10-year maturity period would pay $500 per year for 10 years. When the maturity date arrives, the issuer will pay back the total $10,000 face value.
There is also a secondary market for bonds where investors can buy and sell previously issued bonds. This market allows investors to exchange bonds without waiting until the maturity rate to lock in profits.
Advantages of Bonds
Here are some of the major advantages of bonds as investments.
Bonds Generate Fixed Income
Unlike traditional stocks, bonds generate a guaranteed fixed income for investors. The stock market might be up or down 20% in a given year, but bonds will consistently deliver the agreed-upon interest each period. This interest is essential for investors seeking guaranteed retirement income or those with a capital preservation portfolio strategy.
Bonds Are Safer Than Stocks
The returns on bonds are not subject to the ebb and flow of the stock market. So even in a down year in the overall market, bonds still produce positive gains. Bonds can be effective at diversifying your portfolio to reduce your overall risk.
Disadvantages of Bonds
Here are some of the ways bonds may be a disadvantage in planning your financial goals.
Lower Gains Than Stocks
The primary disadvantage of bonds is the lower reward that comes with their lower risk. In the long run, stocks have historically outperformed bonds in a significant way. So, while bonds are an attractive part of a balanced portfolio, they likely shouldn’t be your sole investment. For example, according to Forbes, the average return of large-cap stocks from 1926 to 2018 was 11.9%, while the return for bonds during the same period was less than 4%.
Companies Can Default
Another disadvantage of bonds is that they are only as good as the creditworthiness of their issuer. Treasury bonds, for example, are not as risky as some corporate bonds, especially junk bonds. There is a risk that the company will default, which means you might lose out on the promised interest or even your entire investment.
Risks of Bonds
While bonds are safer than stocks, they are not entirely risk-free. Here are the common types of risk to be aware of when it comes to bonds.
The creditworthiness of the issuer is one of the principal risks of investing in bonds. There are essentially two categories: investment-grade bonds and junk bonds. Junk bonds can pay more but come with higher risk.
Bonds are not as liquid as many major stocks. While there is a secondary market for exchanging bonds, it might not be financially advisable to sell your bond depending on interest rates, the overall economy or the stock market’s current state. Thus, you may be stuck with your bond investment until the maturity date.
Inflation is a threat to the fixed-rate nature of bonds. If there is significant inflation between the time you purchase a bond and the maturity date, your purchasing power may be much less than your original investment would have been. Beyond the interest rate payments, your invested capital does not grow with bonds.
- Bonds are loans given to an issuer that pays interest until the maturity date.
- Bonds come with fixed rates of return.
- You can invest in bonds in the short term or long term.
- Bonds are less risky than stocks but generate lower profits.
- The risk of the bond depends on the creditworthiness of the issuer.
- There is a secondary market for the exchange of bonds.
Think that bonds are right for you? Read our guide to learn how to choose the best types of bonds to buy.
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- TreasuryDirect. "Individual - Treasury Securities & Programs."
- U.S. Securities and Exchange Commission. "What Are High-Yield Corporate Bonds?"
- TreasuryDirect. 2019. "Using Your Income Tax Refund To Buy Paper Savings Bonds."
- Forbes. 2020. "Historical Market Returns."