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Friday, June 02, 2023

Bonds: What they are & how they work

Bonds: What they are & how they work

bonds

By
The Currency editors

05.07.2023

Getting started with investing and continuing to build wealth over time requires knowledge and patience. There are many types of investments to consider, one of which being bonds.

Read on to find out more about how bonds support a diversified portfolio.

What are bonds?

Bonds are a type of loan packaged up in securities you invest in. Every bond is a unit of debt. The bondholder is the creditor, and the bond issuer is the debtor. Typically, bonds are issued by governments or companies.

Bonds are also called fixed-income investments or fixed-income securities because the income you make from them is a known quantity when you make the investment. 

How do bonds work?

There are many types of bonds1 available, but they work overall the same way:

  • A business, a government or another entity decides it needs or wants to raise funds.
  • The entity sells bonds, which are packaged units of debt that the entity now owes the bondholders.
  • When the bonds are issued, the details of the terms are spelled out, including when the money will be paid back and at what interest.
  • People buy bonds as investments.
  • When the bond matures, the investor receives back the principal loan amount.

Bond vs. loan: what's the difference?

Bonds and loans are both debt instruments. In short, that means they are both ways for one party to gain funding while agreeing to pay other parties back the money at a later date. Bonds are tradable securities, though. You can buy and sell bonds in a marketplace.

The repayment process is also different for bonds and loans. With a loan, the borrower is typically required to make regular principal payments to the debt holder throughout the term of the loan. For example, if you have a car loan, you make a monthly payment that includes principal and interest during the entire term of the loan until you pay it off.

The principal amount of bonds are usually paid back at the maturity date rather than through regular payments. If you buy $5,000 in bonds at issuance that mature in 10 years, you get the $5,000 back in 10 years. You also receive periodic interest payments — typically every six months.

Features of bonds

To better understand how bonds work, following are a handful of the common features of bonds. 

Creditworthiness impacts interest rates

Because bonds are, in fact, debts, the bond issuer's creditworthiness impacts what interest rates are paid. If you invest in bonds for a business that has a low credit rating, the interest rates may be higher. That means you can earn at a higher rate, but it also means you have more risk. A lower credit rating indicates the business is less likely to pay its debts than a business with a higher credit rating.

Understanding this feature of bonds helps you manage your risk tolerance when investing in bonds. It's also worth noting that government bonds, and especially federal bonds, are typically considered lower-risk investments. Many people use them as a savings tool..

Bonds can be resold

If you invest in marketable bonds, you can sell them via the market before the maturity date. This means you can sell the bond for some amount of cash earlier than when the bond matures in 10, 20 or 30 years. 

Some reasons people might sell bonds include worries about the financial stability of the bond issuer, trending market prices that make it smart to sell now or a belief that interest rates will rise significantly soon. When interest rates rise, bonds you're holding often lose value. Note, however, that you can't sell certain types of bonds that aren't marketable, such as government savings bonds. 

Market value is tied to interest rates 

The overall value of marketable bonds is closely tied to interest rates. Rising rates usually mean decreasing values for bonds you already hold. 

This is because having high-interest rates in the market means new bonds issued in that environment will have higher rates. Those are more attractive to investors, so the value of older bonds with lower interest rates may be discounted so they can be effectively traded. 

Hold time

Hold time, or hold period, is how long you own the bond. If you hold the bond until maturity, the hold period is equal to the maturity period. If you sell the bond before it matures, the hold period is from the date you bought the bond to the date you sold it.

Hold time can be an important factor in how much you might earn on the bond. For example, say you buy a $1,000 bond with a 5% interest rate. The issuer will pay you 5% in interest every year on the $1,000 bond — that's $50 per year. If you have a hold time of 10 years, that's $500 in interest. Compare that to a 20-year hold time, where the interest earned is $1,000.

Key terms

Whether you're investing in bonds or reading up about them, you'll come across a few key terms. Here's a quick glossary to help you understand those terms.

Coupon

Coupon rate refers to how much interest the bondholder earns annually on the bond. You might also run across the term coupon dates, which detail when the bond issuer will make interest payments. 

Yield

The yield on any investment is how much you earn. It's typically expressed as a percentage, but it can be a dollar amount. 

Face value

Face value is the amount the bond is worth (what it will pay out) on the maturity date. This may be more or less than what someone paid for it, depending on when and how it was purchased in the market.

Price

Price is how much someone pays for a bond. You have the issue price, which is the original price set by the bond issuer. The price of bonds on the market can go up and down when people sell them due to interest rates and other market forces. 

Types of bonds

There are various types of bonds that each work slightly differently. 

U.S. treasuries

U.S. treasuries are issued by the federal government. They include:

  • Treasury bills. Also called T-bills, these are short-term bonds. They usually mature in a year or less.
  • Treasury notes. Also called T-notes, these are marketable federal bonds, which means you can sell them. They typically mature in 2 to 10 years. 
  • Treasury bonds. Also called T-bonds, these are federal bonds that mature in 10 to 30 years. If you hold one of these bonds, you receive interest payments every 6 months until the bond's maturity. 
  • Treasury Inflation-Protected Securities, or TIPS. The value of these securities is designed to adjust with inflation. This can be one way investors might prepare for inflation in their portfolios. 
  • Separate Trading of Registered Interest and Principal of Securities, or STRIPS. This is a way you can trade components of T-bonds, T-notes and TIPS separately. With STRIPS, an investor can hold principal value separately of interest value, and vice versa. 
  • Floating rate notes. These are short-term securities that pay interest four times annually. They typically mature in two years, and the interest rate can change during that time.

Government agency bonds

Government agency bonds are those that are issued by government entities but aren't U.S. treasury bonds. The exact details of the bonds differ by agency and bond issuance, but most pay a fixed interest rate every 6 months. These bonds are federally sponsored or issued by government agencies such as Freddie Mac or Fannie Mae.

Municipal bonds

The federal government isn't the only government that can issue bonds. When bonds are issued by states or local governments, they are known as municipal bonds. 

Corporate bonds

Corporate bonds are those issued by corporations. They are typically marketable, which means you can buy them directly from the bond issuer or later in the secondary market. 

How are bonds priced?

The original issue price of the bond is typically just the face value — what the person will get back on the maturity date. For example, if you buy a $1,000 bond with a 3% coupon rate and a 10-year maturity, you pay $1,000. You get 3% per year interest, for total earnings of $300 over the 10 years, and you get the $1,000 back at the 10-year mark. 

However, marketable bonds that you can sell have prices that fluctuate with the market — specifically with interest rates. When interest rates rise, existing bonds paying at lower rates decrease in value. So, for example, a bond with a face value of $1,000 might have a price in the market of only $980 due to those market forces. 

Are bonds a good investment?

Government bonds are generally considered fairly safe long-term investments. Whether other types of bonds are a good investment depends on the entity issuing them and what the terms are.

It's important to consider your big-picture financial goals and track your portfolio performance to understand what might be a good investment for you.

Our take

Building a diversified portfolio – which may include bonds – can contribute to a financial plan that weathers the storms of market volatility over time.

If you’re ready to take the next step, consider signing up for our free financial tools to analyze your investment performance, check up on fees, and project long-term returns.

1 Investor.gov, “What are bonds?”

RO2873558-0523

 

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The Currency editors

Staff contributors

The Currency is a personal finance publication powered by Empower and run by a team of writers and editors. We deliver the financial news and views you need to know for life, work and play.

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