What Is a Bond Investment and How Does It Work

A bond is a loan you give to a company or government, and they pay you back with interest

When you buy a bond, you are lending money. The borrower — usually a corporation, city, or the federal government — promises to pay you back the full amount on a specific date, called the maturity date. Until then, they send you interest payments, usually twice a year. That interest is your return on the investment.

Bonds work differently from stocks. When you own a stock, you own a piece of the company. When you own a bond, the company owes you money. If the company goes bankrupt, bondholders get paid before stockholders do, which makes bonds generally less risky.

The interest rate on a bond is set when it is issued and does not change. If you buy a bond that pays 4 percent per year, it will pay 4 percent for the entire time you hold it — even if interest rates in the economy rise or fall.

Key Takeaways

• A bond is a fixed-income investment where you lend money to a borrower who pays you back with interest on a set schedule.
• The interest rate is locked in when you buy the bond and stays the same for the life of the bond, regardless of what happens to market interest rates.
• You can sell a bond before it matures, but its price will go up or down depending on whether interest rates have risen or fallen since you bought it.
• Government bonds are backed by the government's ability to tax and print money, while corporate bonds depend on the company's financial health.
• Bonds are generally considered less risky than stocks because bondholders are paid before stockholders if a company fails.

How bond prices move when interest rates change

Bond prices and interest rates move in opposite directions. If you own a bond paying 4 percent and new bonds come out paying 5 percent, your bond becomes less attractive. If you want to sell it before maturity, you will have to accept a lower price to make up for the lower interest rate.

The opposite happens when interest rates fall. If you own a 4 percent bond and new bonds only pay 2 percent, your bond is worth more. Someone buying it would pay a premium because they want that higher interest rate.

This matters only if you plan to sell before the maturity date. If you hold the bond until it matures, you get back the full face value no matter what happened to its price along the way.

The main types of bonds you can buy

Treasury bonds are issued by the U.S. federal government. They are considered the safest bonds because they are backed by the government's ability to tax and borrow. Treasury bonds come in different lengths: Treasury bills mature in less than a year, Treasury notes mature in 2 to 10 years, and Treasury bonds mature in 20 to 30 years. The longer the maturity, the higher the interest rate.

Corporate bonds are issued by companies. They pay higher interest than Treasury bonds because companies are riskier than the government. The company's financial health determines whether it will pay you back on time. You can buy corporate bonds directly or through a bond fund.

Municipal bonds are issued by states, cities, and local governments to fund projects like roads and schools. In many cases, the interest you earn is not subject to federal income tax, which can make them attractive if you are in a high tax bracket.

Bond funds and bond ETFs let you own a mix of many bonds instead of buying individual bonds. This spreads your risk across many borrowers. The fund manager buys and sells bonds, so the value of your shares goes up and down.

What credit ratings tell you about bond risk

Credit rating agencies like Moody's and Standard & Poor's grade bonds based on how likely the borrower is to pay back the loan. Ratings range from AAA (safest) down to D (in default). A bond with a higher rating pays lower interest because it is safer. A bond with a lower rating pays higher interest because it is riskier.

Before you buy a corporate or municipal bond, check its rating. A bond rated BBB or higher is considered investment-grade, meaning it is relatively safe. Bonds rated below BBB are called junk bonds or high-yield bonds — they pay much higher interest but carry real risk that you will not get your money back.

How to buy bonds

You can buy individual bonds through a brokerage account at firms like Fidelity, Charles Schwab, or Vanguard. You can also buy Treasury bonds directly from the U.S. Department of the Treasury through TreasuryDirect.gov without paying a broker fee.

For most people, bond funds or bond ETFs are simpler than picking individual bonds. You invest a small amount of money and own a piece of hundreds of bonds at once. The fund handles all the buying, selling, and reinvesting of interest payments.

If you buy an individual bond, you will pay a commission or markup to the broker. Treasury bonds bought directly have no fee. Bond funds charge an annual fee called an expense ratio, which is usually between 0.05 and 0.50 percent per year.

The difference between yield and interest rate

The interest rate (also called the coupon rate) is the percentage the bond pays each year. It is fixed when the bond is issued and never changes. If you buy a bond with a 4 percent coupon, you get 4 percent per year.

The yield is the actual return you get based on what you paid for the bond. If you buy a bond at a discount (below face value), your yield is higher than the coupon rate. If you buy at a premium (above face value), your yield is lower. Yield is what matters for your actual return.

When bonds make sense in your portfolio

Bonds are useful when you want steadier, more predictable income than stocks offer. They are often recommended for people who are retired or nearing retirement, because you know roughly how much money you will receive each year.

Bonds also move differently than stocks. When stock prices fall, bond prices often rise, which can balance out your losses. This is why many investors hold both stocks and bonds — the combination is less volatile than stocks alone.

If you need the money within a few years, bonds are safer than stocks. If you can wait 10 or 20 years, stocks have historically returned more over the long run, but bonds provide more stability along the way.

Frequently Asked Questions

Can I lose money on a bond?

Yes, in two ways. If you sell before maturity and interest rates have risen, the price will be lower than what you paid. If the borrower defaults (fails to pay), you may lose some or all of your principal. Government bonds are very unlikely to default, but corporate bonds can.

What happens to my bond if the company goes bankrupt?

Bondholders are paid before stockholders. The company's assets are sold and the money goes first to bondholders, then to stockholders. You may not get the full amount back, but you have priority over stock owners.

Should I buy individual bonds or a bond fund?

Bond funds are simpler if you have less than $10,000 to invest, because you get when ready diversification. Individual bonds make sense if you have more money and want to hold them until maturity to avoid price swings. Bond funds are better if you think you might need to sell before the bond matures.

What is the difference between a bond and a CD?

A CD (certificate of deposit) is a savings product offered by banks, while a bond is a loan you make to a company or government. CDs are insured by the FDIC up to $250,000, but bonds are not. Bonds can be sold before maturity, but CDs usually have a penalty for early withdrawal.