What Is a Bond?

A bond is a loan to a corporation, government agency, municipality, or organization that needs a sizeable amount of money for major projects, such as building roads, buying property, improving schools, conducting research, opening a new factory, or buying new technology.

Bonds can prove helpful to anyone concerned about capital preservation and income generation. Bonds also may help offset the risk that comes with equity investing and often are recommended as part of a diversified portfolio. They can accomplish a variety of investment objectives. Bonds hold opportunity — but, like all investments, they also carry risk.

These concepts are important to grasp whether you are investing in individual bonds or bond funds. The primary difference between these two ways of investing in bonds also is important to understand: when you invest in an individual bond and hold it to “maturity,” you won’t lose your principal unless the bond issuer defaults. When you invest in a bond fund, however, the value of your investment fluctuates daily — your principal is at risk.

How Do Bonds Work?

Bonds operate like home mortgages. The corporation or government agency that issues the bond is considered a borrower. Investors who buy those bonds are considered the lenders.

Investors buy bonds because they will receive interest payments on the investment. The corporation or government agency that issues the bond signs a legal agreement to repay the loan and interest at a predetermined rate and schedule.

If a bond issuer goes bankrupt, its assets pay back investors based on a predetermined “liquidation preference,” which usually starts with bondholders and banks.

Bond Maturity Date

A bond maturity date refers to the specific day when you can cash in your investment. You select your bond’s maturity date when you buy the bond. When your maturity date arrives, the borrower pays you the agreed-upon value of the bond, called the par value.

Lenders put bonds into one of three categories of time: short-term, medium-term, and long-term. Short-term bonds mature in one to three years. Medium-term bonds mature in four to 10 years. Long-term bonds mature beyond 10 years.

Bond Coupon Payments

A bond coupon is the annual interest rate paid on the issuer’s borrowed money, typically paid out semi-annually on individual bonds. The coupon is linked to a bond’s face value, or par value, and is expressed as a percentage of par.

For example, you invest $5,000 in a six-year bond paying a coupon rate of five percent per year, semi-annually. Assuming you hold the bond to maturity, you will receive 12 coupon payments of $125 each, or $1,500.

Accrued interest is the interest that adds up (accrues) each day between coupon payments. If you sell a bond before it matures or buy a bond in the secondary market, you most likely will catch the bond between coupon payment dates. If you’re selling, you’re entitled to the price of the bond plus the accrued interest that the bond has earned up to the sale date. The buyer compensates you for this portion of the coupon interest, which you can usually calculate by adding the amount to the contract price of the bond.

Types of Bonds

Although all bonds share many characteristics, you can choose from several types of bonds. These core bonds include municipal bonds, U.S. Treasury bonds, corporate bonds, and mortgage-backed securities.

Municipal Bonds

Cities, counties, states, and other municipal governments sell municipal bonds (also called munis) to pay for schools, roads, and other public projects. These bonds enjoy low default rates, and ratings agencies like them. They’re backed either by a municipality’s taxing group or by a revenue source, such as a utility or toll road.

Most municipal bonds offer lower yields than corporate bonds because their interest income is often exempt from federal, and sometimes state and local, taxes.

U.S. Treasury Bonds

Financial experts consider U.S. Treasury bonds among the safest investments someone can make. Their default ratio is extremely low (so is their yield), and interest gains are exempt from state and local income taxes.

Bonds are one of three types of treasury investments, which include treasury notes and treasury bills.

Mortgage-Backed Securities

Mortgage-backed securities are an eclectic investment because of their makeup. They’re a package of multiple mortgages, and bondholders get money every month based on the mortgages that are in the package and based on which homeowners pay their mortgages. Also, these bonds rarely redeem according to a schedule. However, the bonds deliver a monthly payment to bondholders.

Corporate Bonds

U.S. companies issue bonds to raise money for large purchases, such as new equipment or buildings, or internal investments, such as an expansion. Corporate bonds are investment grade, with credit ratings of Baa3 (by Moody’s) or BBB- (by S&P). They’re considered low-risk, but they have a higher risk of default than treasury bonds and municipal bonds. These bonds generate interest payments monthly, quarterly, or semi-annually.

Variations of Bonds

Within each type of bond, investors can decide the makeup of their investment.

There are several types of bond structures:

• Zero-coupon bonds: These bonds, also called zeroes, don’t make regular interest payments. You buy the bond at a discount from the face value of the bond, and you receive the face amount when the bond matures.
• Callable bonds: With this bond, the issuer can redeem it before the maturity date. The bond has an embedded call option.
• Convertible bonds: These hybrid bonds combine debt and equity. They pay fixed-income interest payments. However, buyers can also convert them into a predetermined number of stock shares.
• Puttable bonds: This bond has an embedded put option. It allows the investor the ability to ask the issuer to redeem the bond before it matures.

Pros & Cons of Bond Investing

As with any financial investment, bonds have advantages and disadvantages. From a broad view, their risk factor is low. And although they usually deliver consistent returns, investors can make more money by putting their money into stocks and equity funds.

Pros of Holding a Bond

• Bonds have a lower investment risk than stocks and other investment funds.
• Bonds often offer better rates than CDs.
• Coupon payments are sometimes tax-free.

Cons of Holding a Bond

• A callable bond could get called when market conditions are unfavorable to you.
• The security holder could default on the bond payment.
• Interest rate could go down.
• Inflation goes up, decreasing a bond’s value.
• Bonds in foreign currencies can lose their value if that currency weakens.

Choosing a Bond

Bonds are quality investments because of their security and dependability, but their lower returns sometimes cause some people to look for other places to put their money. If you want to add bonds to your portfolio, take time to dig into bond ratings.

A bond rating agency assesses the financial strength of a company or government agency and its ability to meet debt payment obligations, then assigns grades to the offered bonds.

Top-rated bonds have AAA or AA ratings. A and BBB bonds have medium credit quality. Anything below BBB is inferior. Investment experts call these junk bonds.

The U.S. Securities and Exchange Commission recognized three major credit rating agencies — Standard and Poor’s, Moody’s Investor Services and Fitch Group — as the Nationally Recognized Statistical Rating Organizations. Morningstar is another well-regarded ratings agency.

Bond Yield

When financial experts talk about “yield,” they’re referring to the financial gain in an investment. Bonds have different yields, including a coupon yield and a current yield.

A coupon yield is the annual interest rate, which sellers establish at the time of issue. Also called a coupon rate and expressed as a percentage of the original investment, a coupon yield is the amount of income you collect on a bond investment. The rate of return never changes during your investment period.

A current yield is the bond’s coupon yield divided by its current market price. To calculate the current yield for a bond with a coupon yield of 4.5% trading at 103 ($1,030), divide 4.5 by 103 and multiply the total by 100. You get a current yield of 4.37%.

Three terms a bondholder should know:

• Yield-to-Maturity (YTM): This is the rate of return you receive if you hold a bond to maturity and then reinvest all the interest payments at the YTM rate.
• Yield-to-Call (YTC): This rate of return gets calculated to a specific date prior to a maturity date. The rate depends on market conditions on the call date. Many bonds have several call dates.
• Yield-to-Worst (YTW): This is the lowest rate of return you could get from owning a bond — something every bond owner should know. The return is usually for the shortest hold.

If you buy a new bond at par and hold it to maturity, the current yield at the maturation date will be the same as the coupon yield.

A bond’s current yield can be higher than its coupon yield but only when the bond is offered at a discount price.

For more detailed information about investing in bonds and bond funds, visit NASD’s Smart Bond Investing Learning Center at https://www.finra.org/. Besides educational information, this resource provides real-time bond quotations and tools, such as an accrued interest rate calculator.