What Are Bonds and How Do They Work?

A bond is a loan to a company or government that pays investors a fixed rate of return. The borrower uses the money to fund its operations, and the investor receives interest on the investment.

Bonds are a key ingredient in a balanced portfolio and one of the three main asset classes, or groups of investments, frequently used in investing. A bond's risk is based mainly on the issuer's creditworthiness (that is, how likely they are to repay their debts). Interest rates also influence a bond's value.

The market value of a bond can change over time. Long-term government bonds historically earn an average of around 5% annual returns, compared to the average stock market return of 10%.

Most investment portfolios should include some bonds, whose relative safety helps balance out risks associated with stock-based investments. If stock markets plummet, bonds can help cushion the blow.

» Learn about stocks vs. bonds

Types of bonds

Bonds, like many investments, balance risk and reward. Typically, bonds that are lower risk pay lower interest rates. Bonds that are riskier pay higher rates in exchange for the investor giving up some safety.

» Ready to get started? See our best brokers for bond investing

U.S. Treasurys

U.S. Treasurys are considered among the safest investments because they’re issued with the full faith and credit of the U.S. government, which has always paid back its debts. However, they tend to pay lower interest rates than other investments. Treasury bills, Treasury notes, Treasury bonds and Treasury Inflation-Protected Securities (TIPS) differ in their time to maturity and interest rates.

» See how much Treasury bills, notes or bonds could be worth with our Treasurys calculators

Corporate bonds

Companies can issue corporate bonds when they need to raise money. For example, if a company wants to build a new plant, it may issue bonds and pay investors a stated interest rate until the bond matures. The company also repays the original principal. But unlike buying stock in a company, purchasing a corporate bond doesn’t confer a share of ownership.

Corporate bonds can be either high-yield or investment-grade. High-yield means they have a lower credit rating and offer higher interest rates in exchange for a higher risk of default. Investment-grade means they have a higher credit rating and pay lower interest rates due to a lower risk of default.

» Feeling sustainable? Learn about green bonds

Municipal bonds

Municipal bonds, also called munis, are issued by states, cities, counties and other non-federal government entities. Similar to how corporate bonds fund company projects or ventures, municipal bonds fund state or city projects, like building schools or highways.

Municipal bonds can have tax benefits. Bondholders may not have to pay federal taxes on the interest, which can translate to a lower interest rate from the issuer. Munis may also be exempt from state and local taxes if issued in your state or city.

Municipal bonds can vary in term: Short-term bonds repay their principal in one to three years, while long-term bonds can take over ten years to mature.

» Learn more about popular types of bonds

How do bonds work?

When you buy a bond, you first pay the bond’s issuer the face value (or price) of the bond. The bond’s issuer then pays you interest for loaning them money across the life of the bond in return. These regular payments are also known as the bond’s interest rate or “coupon rate”. When the bond matures, the bond’s face value is paid back to you, the investor.

A $10,000 bond with a 10-year maturity date and a coupon rate of 5%, for example, would pay $500 a year for a decade, after which the bond's original $10,000 would be paid back.

» Ready to add bonds to your portfolio? See our guide on how to buy bonds

Are bonds a good investment?

As a general rule of thumb, bonds can be a great addition to your investment portfolio when used strategically alongside stocks and other assets. Bonds are relatively safe and can create a balancing force within an investment portfolio focused on stocks by diversifying the portfolio’s assets and lowering its overall risk.

Bonds represent the purchase of a company or public entity’s debt obligation. They can be a solid asset to own for individuals who like the idea of receiving regular, fixed-income because bonds pay interest at predictable rates and intervals. Certain kinds of bonds, such as municipal bonds, also offer tax breaks.

Stocks earn more interest but carry more risk, so the more time you have to ride out market fluctuations, the higher your portfolio concentration in stocks can be. But as you near your financial goal and have less time to ride out rough patches that might erode your nest egg, you'll want more bonds in your portfolio. With the safety of bonds comes lower interest rates than investing in funds or stocks.

Yet even though bonds are a much safer investment than stocks, they still carry some risks, like the possibility that the borrower will go bankrupt before paying off the debt. The bond issuer may be unable to pay the investor the interest and principal they owe on time, which is called default risk.

If you try to sell before the bond’s maturity, there is always a chance you’ll have difficulty, particularly if interest rates go up. Inflation can also reduce your purchasing power over time, making the fixed income you receive from the bond less valuable as time goes on.

» Learn more about how inflation affects the value of your money with our inflation calculator.

4 key things to know about bonds

1. A bond's interest rate is tied to the issuer's creditworthiness.

Treasurys offer a lower rate because there's less risk the federal government will go bust. A sketchy company, on the other hand, might offer a higher rate on bonds it issues because of the increased risk that the firm could fail before paying off the debt.

Rating agencies such as Moody’s and Standard & Poor’s grade bonds. The higher the rating, the lower the risk that the borrower will default. U.S. government bonds are typically considered the safest, followed by state and local governments and corporate bonds.

2. How long you hold onto a bond matters.

Bonds are sold for a fixed term, typically from one year to 30 years. You can re-sell a bond on the secondary market before it matures, but you risk not making back your original investment or principal.

A bond's rate is fixed at the time of purchase, and interest is paid regularly for the life of the bond. After that, the full original investment is paid back.

Alternatively, many investors buy into a bond fund that pools a variety of bonds to diversify their portfolio. However, these funds are more volatile because they don't have a fixed price or interest rate.

3. Bonds often lose market value when interest rates rise.

As interest rates climb, so do the coupon rates of new bonds hitting the market. That makes the purchase of new bonds more attractive and diminishes the resale value of older bonds stuck at a lower interest rate, a phenomenon called interest rate risk.

4. You can resell your bond.

You don’t have to hold onto your bond until it matures, but the timing does matter. If you sell a bond when interest rates are lower than when you purchased it, you may be able to make a profit. You may take a loss if you sell when interest rates are higher.

With bond basics under your belt, keep reading to learn more about: