If you’ve done a bit of reading on investing, you likely already know that stocks and bonds are the two primary keystones of any investment portfolio. You probably also know that bonds represent loans to an issuer, while stocks represent ownership in a company itself. However, from there, things might get a bit murky.
Just what is a bond? If you’ve ever wondered how bonds work, you’re in the right place.
- Unlike stocks where you own a piece of the company and your gains and losses are reflected in the stock price, a bond is like a loan to the issuer where you earn a fixed interest payment and get your money back at the end of the term of the bond.
- Bonds’ risk is measured in 1) credit risk, meaning the probability of repayment vs. the probability of default, and 2) the time required to get your money back, where longer terms mean higher risk.
- Bonds are more attractive to investors who seek more safety, either due to risk tolerance or their desire for more secure income streams. Most investors would benefit from a balanced portfolio of stocks and bonds.
- Bonds come in a spectrum of 1) government-issued bonds (U.S. Treasuries) that present more assured income at lower rates, all the way to 2) corporate bonds that could be more speculative and offer higher returns.
What Is a Bond?
When you buy a stock, you are essentially buying part of the company. With your stock purchase, you become a part owner of the issuing company. This is not the case with bonds.
When you buy a bond, you are instead lending the issuing institution the value of the bond, or face value, with the agreement that they will pay interest on the loan at a fixed rate — usually annually or biannually — for an agreed-upon period of time. This interest rate, also known as the coupon rate, will not change once the bond is issued in most cases.
In short, a bond is a loan from you — the bond owner — to the company or government body (such as the United States Treasury, a state, or municipality) issuing the bond. As with most loans, lenders earn money by charging the borrower an interest rate on the loan — it’s an IOU from the bond issuer, with interest.
How Does a Bond Work?
In contrast to a stock purchase, the price of a bond, also known as the face value, is agreed upon at the time of purchase. When you buy stocks, the share price can vary greatly — from a few cents to a few hundred thousand dollars. However, when it comes to bond prices, the “face value” (or nominal value of the bond) is usually set at $1,000.
While the face value for most bonds is the same, the length of time you will have to wait to receive the full repayment of that face value can vary greatly. This period, known as a bond’s maturity date, can range anywhere from 1 to 30 years. During this period, the bond issuer pays the agreed-upon interest rate to the bond purchaser in annual or semi-annual payments. Interest rates will vary from issuer to issuer, and depends on the degree of risk you’re taking.
The more reliable the issuer is based on its credit strength, the lower the interest rate. If the issuer has less reliable credit strength, the issuer would typically offer a higher interest rate to attract investors. The time it takes to get your principal back also presents risk. Shorter-term bonds tend to offer lower risk since the issuer is obligated to return your money sooner — less waiting for you to get your money back. Longer-term bonds present a higher risk since you’ll have to wait longer for your principal to return to you.
When you reach the end of the loan term, the bond matures, and the issuer pays you back the full purchase price of the bond. This final payment will also include the last interest payment.
But how does all this translate into income? As an example, let’s say you buy a bond with a face value of $1,000, with a 3% interest rate paid annually, and a 10-year maturity date. How much money would you earn by deciding to purchase that bond?
Let’s break it down:
- At bond purchase: You would “lend” $1,000 to the issuer.
- Each year: You would earn 3% in interest, or $30, a year for 9 years.
- At the end of the 10-year term: You would get back your original $1,000 and the final $30 in interest.
- Over the course of 10 years: If you hold the bond to maturity, your return will be $300 ($30 x 10) before taxes.
While the bond issuer will usually pay you interest over the course of the bond term, punctuated by the full repayment of the face value, there is one exception: a zero-coupon bond. In this case, the bond issuer does not pay annual or semi-anal interest to the lender over the course of the bond term. Instead, the investor purchases the bond at less than its face value, and the full principal is paid out when it matures. As an example, you might buy a 10-year $1,000 face value zero-coupon bond for $600, and at final maturity you would receive the full $1,000 — earning you $400.
Who Should Consider Buying Bonds?
Bonds are usually an integral part of a comprehensive investment strategy. That said, they might not be for everyone. Whether you decide to invest in bonds might depend on your tolerance for risk, your current asset allocation, and your life stage.
Those Who Are Risk Averse
If you’re risk averse, more conservative bonds may be a good choice. Earning $300 to $400 on a $1,000 investment over a 10-year period might seem boring — and that’s exactly the point. Most investors buy bonds in order to diversify their investment portfolios. While watching the rise and fall of the stock market can be exciting, for many, the idea of losing their life savings on what might feel like a wild stock gamble is not appealing. Bonds may be a good option for these individuals, as high grade bonds (those that pay lower interest rates, but also present lower risk) have smaller price swings than stocks over time.
Those Who Need to Diversify Their Portfolio
It’s true that in the long term, stocks generally outperform bonds. However, bonds offer a stable counterbalance to the ups and downs of the stock market, and can help even out the lows you might suffer during a recession with their stable, predictable returns. In most cases, an investor would be wise to have a mix of stocks and bonds in their portfolio: stocks to participate in any upside in company value, and bonds to provide predictable income streams over time.
Those Who Are Close to Retirement
Another factor to consider when you decide to invest in bonds is your stage of life. For example, if you’re young and still working, you may not rely heavily on your investment income to weather a dip in the market. However, retirees who no longer have earned income need an alternative, steady income stream from a reliable source. At their advanced age, they would suffer greatly if their retirement income relied entirely on stock returns during a bear market since they cannot wait years for the market to recover. With bonds, retirees can often depend upon the steady income that bonds generate, and can rely on the value (especially of high grade bonds) so as not to lose their retirement savings.
What Types of Bonds Are Available?
While the face value of most bonds may be the same at $1,000, the quality of bonds can vary drastically based on the issuer. There are various types of bonds to consider, each of which has pros and cons for the individual investor.
Perhaps the most secure of all bonds are those issued by the United States Treasury, as they’re backed by the full faith and credit of the U.S. government. These come in various forms, with the most common being:
- Treasury bills: T-Bills have a maturity of 1 year or less, and are issued as zero-coupon bonds.
- Treasury notes: T-notes have maturities ranging from 2 to 10 years.
- Treasury bonds: T-bonds have some of the longest maturities — usually more than 10 years, but most commonly 30 years.
- Treasury Inflation Protected Securities (TIPS): These have an interest rate that mirrors the national inflation rate. If interest rates rise, so does your return on investment.
U.S. Savings Bonds
Unlike most bonds, these can be purchased for as little as $25 directly from the U.S. Treasury at TreasuryDirect, and come in two types: Series EE bonds and Series I bonds.
Series EE Savings Bonds
The Series EE bonds offer a fixed interest rate, and are guaranteed to double in value over the bond term, which is usually 20 years. These types of bonds can be cashed in early, but the owner will pay a penalty worth three months of interest if the cash in occurs within five years of the initial purchase.
Series I Savings Bonds
The Series I savings bonds are not guaranteed to double in value. Instead, I bonds are issued for a 30-year period with a fixed rate of return for the life of the bond, plus an inflation-adjusted interest rate that is adjusted every six months based on the Consumer Price Index (CPI), in May and November.
Because the savings bonds are so secure — and are almost risk-free — the interest rate tends to be very low. As a result, interest payments may not keep pace with inflation, and you might end up earning less on your investment than if you’d placed it in a high-interest savings account. Additionally, you have to pay federal income tax on any interest earned from these types of bonds, but they are usually exempt from state tax.
Also known as “munis” or “muni bonds,” this type of bond is issued by state and local governments, usually to raise money for municipal bond funds that supply the capital for projects benefiting the public, such as hospitals, schools, roads, or airports. In return for providing funding for public works projects, the municipality agrees to repay the investor with the revenue raised from a specific project.
General obligation bonds, or GO bonds, are also a type of municipal bond used to raise funds for projects that benefit the public. The way the local government guarantees repayment differs from other municipal bonds. With GO bonds, the municipality pledges to repay the bondholder using all available resources, including through the tax revenues generated by the project being funded, as well as through the levying of property taxes.
While these bonds are generally safe, they’re not as safe as bonds issued by the federal government. However, the upside is their tax-exempt status, as you generally won’t have to pay federal taxes on the interest income payments you receive. Also, if it’s bond from the state in which you live, you won’t have to pay state taxes on the interest, and if it’s a local bond from the city or municipality you call home, you also won’t have to pay local taxes. While the tax-free status is definitely appealing, there is a caveat. In general, these types of bonds require a high minimum investment of at least $5,000 for an individual bond.
The bond issuer in the case of a corporate bond is — you guessed it — a corporation. Private sector companies issue bonds, usually with a face value of $1,000, to finance new purchases or acquisitions. Because these are issued by companies and not government entities, these are taxable bonds, with federal and state tax usually due on any interest payments.
These bonds also pose a higher risk to the investor because they’re more likely to be affected by the ups and downs of the stock market. However, with greater risk comes greater return. As such, these bonds often have a much higher interest rate than more secure government and municipal bonds.
Social Impact Bonds
For investors interested in impact investing or social finance, social impact bonds (SIBs) are a good option to consider. Also known as pay for success bonds, social benefit bonds, development impact bonds, or pay for success financing, these bonds are a relatively new addition to the private investment world. The first social impact bond was issued in 2010.
Social impact bonds are issued by public sector organizations or governing authorities to help service providers improve social services. The bond issuer agrees to create better social outcomes in a certain geographic location (many are issued in developing countries), address a particular social problem, or improve certain public services using the capital provided by the investor as a financing mechanism. In turn, any monetary savings realized as a result of addressing these social issues is passed onto the investor.
Perhaps the most well-known instance of social impact bonds thus far were those issued by Peterborough prison in the United Kingdom in 2011. These were the first social impact bonds issued anywhere in the world, raising £5 million from 17 social investors to fund a pilot program intended to reduce the re-offending rates of short-term prisoners in the U.K. In this case, the lower the re-offending rate of prisoners after release from Peterborough, the more money investors will earn on their bonds.
Social impact bonds have also been issued in Australia, California, and New York. Most bonds thus far have been issued by public organizations — although private sector companies such as Goldman Sachs have also entered into the space — with a focus on improving the criminal justice system, reducing homelessness, and even improving early childhood development.
Unfortunately, it can be difficult to gauge the success of some social programs, given that social impact is not an easily quantifiable metric. As a result, social impact bonds can be a bit of a risky investment for those who want predictable financial returns.
How Risky Are Bonds?
While we’ve seen that bonds can be less risky investments than stocks, that’s not to say they’re completely secure. All bonds carry a credit risk that the issuer might default, but the good news is that it’s a risk that has been measured by professionals. Bond credit ratings agencies such as Standard & Poor and Moody’s evaluate bond issuers’ ability to repay the bond, and grade them accordingly:
- AAA: The most secure bonds are those with an AAA rating. These are the highest quality bonds on the market, and usually include U.S. Treasury Bonds, although corporate bonds can also achieve an AAA rating.
- BBB: These are still investment-grade bonds, but the likelihood of the issuer defaulting on their interest payments — or failing to pay back the face value of the bond entirely — is higher. As a result, BBB-rated bonds usually have higher yields than their more secure AAA-rated cousins.
- BB to CCC: As you might expect, this range of bonds carries an even higher risk that the issuer will default on their payments, and are considered highly speculative. Due to the greater risk, these are high-yield bonds with higher interest rates designed to attract investors. Since they fall out of the investment grade bond ratings, these bonds are also known as “junk bonds.”
- D or C: These bonds are already in default, and are generally not a wise investment option.
Bonds Help Steady the Ship
Bonds are a subset of low-risk investment strategies that add a measure of stability to any investment portfolio. They can usually be relied upon to provide a steady stream of income, even when the stock market hits a rough patch, and are therefore an excellent option for investors who don’t wish to put all their hard-earned money at risk. With a well-diversified portfolio — including both stocks and bonds — you can be more confident your future will be smooth sailing.