What Is a Bond? Guide to How Bonds Work

A bond is a loan made to an organization by an investor in exchange for interest. Any organization can issue bonds, including governments, and bonds can be traded and issued like stocks. There are no shares or equity involved in bonds; companies pay back yield, or interest, to bondholders for a predetermined period—usually 30 years—before repurchasing the bond in full.

Bonds are a lower-risk investment than stocks because they deliver consistent interest payments but are not risk-free, especially if the company issuing the bonds goes bankrupt during the bond period. In that case, a bondholder might not receive the total amount of the bond’s principal at the end of the loan’s term.

Organizations, companies, and governments typically issue bonds when they need an influx of cash flow to finance projects or raise capital. Bonds can either be privately traded, publicly traded, or traded over-the-counter (i.e., a trade not made on a formal exchange). Bond issuers usually set the initial bond price at par value (or face value), typically either $100 or $1,000.

When borrowers issue the bond to the lender, they also set the maturity date—the date the loan must be paid back—and determine the coupon payment or the annual interest payment sent to the bondholder. The borrower must pay back the bond’s face value to the lender once it reaches its maturity date. The bond's market price will vary depending on the time until it expires, the bond's grade issued by a credit rating agency, and the coupon rate (i.e., the rate of interest). A bondholder does not have to keep a bond for the entire bond's lifetime. It's common for bondholders to resell bonds on a secondary market before they reach their maturity date.

There are several different types of bonds on the bond market:

1. 1. Corporate bonds: A corporate bond is essentially a loan from bond investors to a company. They are considered riskier than government or municipal bonds but also offer the chance for higher returns. Investors avoid high-risk bonds by referring to bond ratings from credit rating companies, which judge the probability of default on a debt. Bonds with a low default risk are considered investment grade, while loans with a higher default risk (and lower credit rating) are known as junk bonds.
2. 2. Government bonds: Also called treasury bonds, a government bond is a loan made to a government, which issues repayment of the principal in full to the bondholder with interest. There are several different kinds of federal government bonds, including treasury bills and treasury notes from the US Treasury. Government bonds typically offer less risk, especially if the country is established and stabilized, but they usually provide a lower return.
3. 3. Municipal bonds: Also called "munis," municipal bonds are similar to government bonds, but the issuer is a municipality—a city, town, or state—seeking to fund local government infrastructure projects like schools or health resources.
4. 4. Zero-coupon bonds: These bonds have fixed interest rates and no periodic interest payments. Instead, they offer long-term returns by accruing interest and paying out at the bond's maturity date. Zero-coupon bonds are vulnerable to interest rate risk and have high volatility on the open market.
5. 5. Agency bonds: The issuer of these bonds is a government-affiliated organization or a corporation granted a charter by the government. Agency bonds are comparable to US Treasury bonds but typically have slightly higher interest rates. While you'll have to pay federal taxes on your returns no matter what, you can find agency bonds that are not subject to local taxes.

There are several critical differences between bonds and stocks, including:

1. 1. Equity and debt: Stocks provide investors with equity, which is partial ownership of a company that can be quickly converted into cash. They offer the promise of future income with the health and success of the company. Bonds, by comparison, offer no ownership option but do promise the repayment of a loan with interest.
2. 2. Fixed income and capital gains: To make a capital gain or profit from stocks, they must sell at higher stock prices than what the stockholder initially paid for them. Capital gains can then be turned into cash or reinvested, but they are taxed as either long-term or short-term capital gains. Bonds generate funds through their regular interest payments, though they can also be sold on the bond market as capital gains.
3. 3. Rising and falling: Stocks and bonds typically have what’s known as inverse performance. When stock prices are high, investors usually want to take advantage of that increase, which generates more demand for stocks and, in turn, a decrease in bond prices. But when stock prices fall, investors turn to the stability of bonds, which causes stock prices to drop.

As an investment, bonds can boast the following benefits:

1. 1. Low risk: Bonds are a lower-risk investment than stocks because they deliver consistent interest payments. If you keep the bond to maturity, you will also earn your principal payment back—unless the bond issuer goes bankrupt.
2. 2. Portfolio diversification: Having bonds in your portfolio is beneficial when there's a volatile stock market. Investing in a bond fund can also reduce your risk by diversifying your portfolio across multiple bond issuers. This way, if one bond issuer defaults, you'll still have several other bonds in your mutual fund to make up for it.
3. 3. Verified ratings: Credit rating agencies like Moody's and Standard & Poor's assign bonds a rating based on their risk of default. Ratings range from AAA for bonds with the lowest credit risk (best quality) to C for bonds with the highest credit risk (worst quality).

Even though bonds are among the more low-risk investments, there are still some drawbacks.

1. 1. Interest rate risk: When interest rates rise, bonds tend to decrease in market value. Long-term bonds are especially vulnerable to interest rate risk.
2. 2. Inflation risk: Except for variable-rate bonds, bonds can lose some of their value if government policies lead to a high inflation rate. Since bonds have a lower rate of return than stocks, they may struggle to outpace inflation and lose some of their value.

All investments and investment strategies entail inherent risks and introduce the potential for financial loss or the depreciation of assets. The information presented in this article is for educational, informational, and referential purposes only. Consult a professional investment advisor before making any financial commitments.

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