If you searched “bomd,” you were most likely looking for information about a bond. A bond is a loan you make to a government, municipality, or corporation in exchange for regular interest payments and the return of your original investment at a set date in the future. Bonds are one of the core building blocks of investing, sitting alongside stocks and cash as the three main asset classes most people encounter.
How Bonds Work
When you buy a bond, you are lending money to the issuer. In return, the issuer agrees to pay you a fixed interest rate (called the coupon rate) on a regular schedule, usually every six months. At the end of the bond’s term, known as its maturity date, the issuer pays back the original amount you lent, called the face value or par value. Most bonds have a face value of $1,000.
For example, if you buy a 10-year bond with a $1,000 face value and a 4% coupon rate, you’ll receive $40 per year in interest (typically split into two $20 payments). After 10 years, you get your $1,000 back. The total you earned over the life of the bond is $400 in interest plus your original investment.
Types of Bonds
Bonds come in several varieties, and the type you choose affects the risk you take and the return you can expect.
- Treasury bonds: Issued by the U.S. federal government, these are considered among the safest investments in the world because they’re backed by the full faith and credit of the government. They come in several forms: Treasury bills (maturing in one year or less), Treasury notes (2 to 10 years), and Treasury bonds (20 or 30 years).
- Municipal bonds: Issued by state and local governments to fund public projects like schools, roads, and hospitals. A key advantage is that the interest you earn is often exempt from federal income tax, and sometimes from state and local tax as well.
- Corporate bonds: Issued by companies to raise capital. These typically pay higher interest rates than government bonds because they carry more risk. If the company runs into financial trouble, it might not be able to make its payments.
- Agency bonds: Issued by government-sponsored entities like Fannie Mae or Freddie Mac. These fall somewhere between Treasuries and corporate bonds in terms of risk and return.
Why Investors Buy Bonds
Bonds serve a different purpose in your portfolio than stocks do. Stocks offer the potential for higher long-term growth, but their prices swing more dramatically. Bonds provide a steadier, more predictable stream of income. Many investors hold a mix of both to balance growth potential with stability.
Retirees and people approaching retirement often increase their bond allocation because they need reliable income and can’t afford to wait out a stock market downturn. Younger investors might hold fewer bonds and more stocks, since they have time to ride out volatility.
How Bond Prices Move
Bond prices and interest rates move in opposite directions. When interest rates rise, existing bonds with lower coupon rates become less attractive, so their market price drops. When rates fall, existing bonds with higher coupons become more valuable, pushing their price up.
This only matters if you sell a bond before it matures. If you hold it to maturity, you’ll receive the full face value regardless of what interest rates did in the meantime. But if you need to sell early, you could get more or less than you originally paid depending on current rates.
Bond Ratings and Risk
Rating agencies assign grades to bonds based on how likely the issuer is to make its payments. Bonds rated BBB or higher (on the Standard & Poor’s scale) are considered “investment grade,” meaning they carry relatively low risk of default. Bonds rated below that threshold are called “high-yield” or “junk” bonds. They pay higher interest rates to compensate investors for the added risk that the issuer might miss payments or go bankrupt.
Even within the investment-grade category, there’s a range. A bond rated AAA is considered extremely safe, while one rated BBB is still investment grade but closer to the line. Checking a bond’s rating before buying gives you a quick sense of how much risk you’re taking on.
How to Buy Bonds
You can buy Treasury bonds directly from the U.S. government through TreasuryDirect.gov with no fees. For corporate and municipal bonds, you’ll typically go through a brokerage account. Individual bonds can be harder to research and compare than stocks, so many investors opt for bond mutual funds or bond ETFs instead. These funds hold hundreds or thousands of bonds, giving you instant diversification and professional management for a small annual fee.
Bond funds don’t have a fixed maturity date the way individual bonds do, which means their value fluctuates with interest rates on an ongoing basis. If you want the certainty of getting your full principal back on a specific date, individual bonds or bond ladders (a strategy where you buy bonds maturing at staggered intervals) may be a better fit.