What is a Bond?

If you want to earn a higher return than you get with a savings account, but you worry about the volatility of the stock market, then investing in bonds could be a good compromise. Bonds are generally safer investments than stocks and can offer a reliable source of income. 

But what is a bond, and how do they work? Continue reading to learn the ins and outs of investing in bonds. 

What is a bond?

A bond is a popular investment option. They’re known as debt instruments, meaning you’re lending money to the entity that issued the bond. Issuers can be government agencies or corporations raising money for their operations or projects. For example, a county may sell bonds to get the money it needs to improve roadways. 

How do bonds work?

In the world of investing, bonds function like IOUs. The issuer uses bonds to raise money, so by investing in bonds, you are lending the issuer the cash it needs. In exchange, the issuer agrees to pay you interest, usually at a fixed rate. 

Bonds have maturity dates, which is the predetermined date a bond issuer must repay the bond principal. When the maturity date arrives, the issuer repays what you originally invested plus interest that has accrued. 

If you want to cash out before the bond reaches its maturity date, you can sell the bond in the secondary market. But you may not get back what you originally invested if prices and interest rates have changed since you purchased the bond. 

3 types of bonds

There are three main types of investment bonds: 

Corporate bonds

Corporate bonds are issued by companies that need to raise money to fund projects, such as building a new facility or conducting research and development. The company issuing the bond makes a legal commitment to pay interest on the bond’s principal and repay the bond’s value when the bond matures. 

Although corporate bonds are generally less risky than stocks, they do have some level of risk. The issuing company may default on their payments or even collapse altogether. 

Municipal bonds

Municipal bonds are issued by states, counties or cities. These bonds are typically sold to raise money for projects like building schools or highways. 

In return for the bond, the issuer agrees to pay interest and return the bond principal once it reaches its maturity date. The interest on municipal bonds is often exempt from federal income tax, and it may even be exempt from state or local taxes. 

Treasury bonds

Treasury bonds are issued by the U.S. Department of the Treasury. They are backed by the full faith and credit of the U.S. government, so they’re generally regarded as one of the safest investment options. 

Bond ratings

Before investing in bonds, it’s important to understand bond ratings and their impact on the bond market. Credit-rating agencies designed bond ratings as a way to gauge the default risk of an issuer and to determine its likelihood of paying its debt obligations on time. 

Depending on its rating, a bond can be categorized as “investment grade” or “noninvestment grade.” 

Investment grade

These bonds have a higher likelihood of being paid on time. 

Noninvestment grade

These bonds tend to pay a higher interest rate, but they have a higher risk of default. 

Bond interest rates

Generally, bonds provide lower returns than stocks, but that’s because they’re a lower-risk investment. For example, the historical average annual return of an investment portfolio that’s 100% invested in bonds is 6.3%. By contrast, a portfolio that’s 100% invested in stocks has an average annual return of 12.3%.

How are bonds priced? 

When you invest in bonds, you want to predict whether they’ll provide a good return on your investment. The bond’s price can help you make that determination. 

A bond is issued with a set face value. Its market price can change depending on what an investor is willing to pay for it. When the price is equal to the face value of the bond, it trades “at par.” The bond may trade at a “premium” when its price rises above the face value or trade at a “discount” when it sells for less. 

Bonds have fixed interest rates that are based on the current rate of inflation, the issuer’s creditworthiness and the current market rate. But what you receive as a yield can change based on how the bond’s price fluctuates. 

When interest rates increase, the demand for existing bonds falls, and prices drop. That result is because the new bonds with higher rates are much more attractive to new investors, so existing bonds with lower rates have less value to investors. 

What are bond yields?

The term “bond yield” refers to the return — or the money you get — when you invest in a particular bond. The bond’s price and its yield are inversely related. So when the price of a bond goes up, its yield goes down. And when the price of a bond decreases, the yield increases. 

There are two core bond yield concepts to know: 

Coupon yield

The coupon yield, sometimes referred to as the coupon rate, is the annual interest rate that is set when you purchase the bond. The coupon yield or coupon rate never changes. 

Current yield

The current yield is the coupon yield divided by the current market price for the bond. If the bond price has changed since its issue date, the current yield also changes. 

Bond maturity 

The bond maturity date is the date when the issuer has to repay the bond’s principal amount. 

Based on their maturity date, there are short-term and long-term bonds, and some fall in between. These are the maturity lengths you might find on a bond: 

• Short-term: These bonds have maturity dates within three years. 

• Mid-term: Mid-term bonds mature within four to 10 years. 

• Long-term: Long-term bonds mature in 10 or more years.

Generally, long-term bonds are riskier than short-term bonds. Interest rates can fluctuate for a longer period of time, which can affect the bond’s value. 

Stocks vs bonds

Stocks, also known as equities, give you a slice of ownership in a publicly traded company. When you invest in stocks, you can earn money when the value of the stock increases. Some stocks also provide dividends, which are shares of the company’s profits that it passes on to investors. 

Stocks are traded on the major stock exchanges (i.e. New York Stock Exchange). Prices depend on several factors, including the company’s performance and overall investor confidence in the market. Stocks can be volatile, with prices fluctuating a great deal. Stocks tend to provide higher long-term returns than bonds, but they also pose a higher level of risk. 

Bonds: Pros and cons

Before investing in bonds, make sure you understand their benefits and drawbacks: 

Pros

• They provide a reliable source of income: Bonds can produce a steady, reliable source of income. Bondholders usually receive interest payments at regular intervals, such as every six months.  

• They are a lower-risk investment: Compared to stocks, there’s generally less risk of losing money in bonds. Plus, you can earn regular interest on top of your principal once the bond reaches its maturity date. 

• They have higher returns than savings or certificates of deposit (CDs): Compared to other lower-risk options, such as investing in CDs or depositing money into a savings account, bonds typically produce higher returns. 

Cons 

• They provide lower returns than some investment options: Bonds usually produce lower returns than other investments, such as stocks, mutual funds or exchange-traded funds (ETFs). 

• Bonds are not risk-free: Despite being considered a lower-risk investment option than stocks, bonds aren’t a risk-free investment. There’s some level of risk that an issuer will default on bond payments. Plus, fluctuations in interest rates can cause the bond’s value to drop. 

• Bonds are not liquid: It can be challenging to get the money you need quickly if your money is tied up in bonds. If you need to sell the bond for less than its purchase price, you’ll lose money in the trade. 

How to buy bonds

There are several ways to buy bonds: 

Broker

You can buy bonds through a brokerage firm or online broker. To get started, you can open a brokerage account online. If you choose this approach, you’ll buy bonds from other investors on the secondary market. 

Mutual funds and ETFs

Mutual funds and ETFs allow you to invest in hundreds of bonds at once. Depending on your goals, you can invest in funds that invest primarily in short-, mid- or long-term bonds. You can also decide to invest primarily in bonds in a particular industry. 

Direct from the government

You can buy government bonds directly from the government agency that issues them. In the case of Treasury bonds, you can buy them online at TreasuryDirect.com. 

Are bonds a good investment?

Although bonds have historically provided lower average returns than stocks, they can still be a good investment option. They provide higher returns than some other investment options, and they come with less risk compared to stocks. Investing in bonds can also produce a reliable stream of income.

Depending on your age and investment goal, you may invest in both bonds and stocks. Bonds can provide some protection against economic downturns, while stocks increase your portfolio diversification and long-term growth potential.

When you’re young and investing for long-term goals, such as retirement, your portfolio allocation may be mostly in stocks. But as you get closer to retirement age, your portfolio allocation may be more heavily invested in bonds to reduce your risk. 

With Acorns Invest, you can answer questions about your age and investment goals, and Acorns will provide you with a recommended portfolio of ETFs that may contain both stocks and bonds.