What are Bonds? Understanding Bond Types and How They Work

In this article, the Just2Trade team will tell you everything you need to know about bonds: what a bond is, how it actually works, whether it's a good investment, what the main types of bonds are and the advantages and disadvantages of each type, as well as the financial meaning of a bond. So let's go ahead and get to it! Don't forget to take some notes!

Table of Contents

What is a Bond?

Key Takeaways

Who Issues Bonds?

How Do Bonds Work?

Bond terms to know

Why buy bonds?

Types of Bonds

How are Bonds Priced?

Examples of Bonds

What are the risks associated with bonds?

How can I buy bonds?

The Bottom Line

FAQ

What is a Bond?

First of all, let's find out what a bond is. An investor makes a loan to a borrower by issuing a fixed-income security known as a bond (typically corporate or governmental). The terms of the loan and the payments are outlined in a bond, which can be compared to an I.O.U. between the lender and borrower. Companies, towns, states, and other sovereign entities all use bonds to finance their operations and capital expenditures. Owners of bonds are debtholders or creditors of the issuer.

The final date on which the loan's principal is scheduled to be repaid to the bond owner is included in the specifics of the bond, as are, typically, the conditions of the borrower's variable or fixed-interest payments.

Key Takeaways

• Bonds are tradable assets that are securitized versions of corporate debt issued by businesses.
• Since bonds have historically paid debtholders a fixed interest rate (coupon), they are referred to as fixed-income instruments.
• Interest rates that fluctuate or float are also rather typical today.
• Interest rates and bond prices are inversely associated: when rates rise, bond prices decline, and vice versa.
• Bonds have maturity dates, after which the full principal must be repaid to avoid default.

Who Issues Bonds?

Bonds are a type of debt instrument that represents a loan given to the issuer. Bonds are a frequent tool used by enterprises and governments (at all levels) to borrow money. Roads, schools, dams, and other infrastructure must be funded by the government. Other sudden costs, such as disaster relief and emergency aid, might also bring on the necessity for fundraising.

Similar to individuals, businesses frequently borrow money to expand, purchase real estate and equipment, carry out profitable initiatives, conduct R&D, or hire personnel. Large organizations frequently require far more funding than the ordinary bank can offer, which is a concern.

Bonds offer a solution since they let many different investors play the part of the lender. In fact, public debt markets allow tens of thousands of investors to lend a share of the required money to each other. Furthermore, bond markets enable lenders to sell bonds to other investors or purchase bonds from other investors long after the initial issuing institution has acquired funds.

How Do Bonds Work?

Along with stocks (equities) and financial assets, bonds are a common name for fixed-income securities and one of the key asset types that individual investors are typically familiar with.

Bonds may be directly sold to investors when businesses or other entities need to raise funds to support ongoing operations, fund new initiatives, or restructure existing debt. The borrower (issuer) issues a bond which includes the terms of the loan, interest payments to be made, and the deadline (maturity date) for repayment of the borrowed funds (bond principal). Part of what bondholders receive in return for lending money to the issuer is the interest payment (the coupon). The coupon rate is the interest rate, which determines how much will be paid.

Most bonds have their starting price fixed at par value, which is usually $1,000 face value per bond. The real market price of a bond is determined by a variety of variables, including the issuer's credit standing, the remaining time before expiration, and the coupon rate, which corresponds with the current environment of interest rates. When the bond matures, the holder will receive a payment equal to its face value.

Following their issuance, the majority of bonds can be sold by the original bondholder to additional investors. In other words, a bondholder is not required to keep a bond until it matures. The borrower will frequently buy back bonds if interest rates fall, or if they can issue new bonds at a reduced price due to improved credit.

What makes a bond a bond?

At its core, a bond is a loan you're giving to a bond issuer, like governments issuing treasury bonds or companies selling investment-grade debt. In return, the issuer promises regular interest payments until the bond matures, at which point the original value of the bond is repaid. What's unique about bond investments is their predictability - unlike stocks, bonds provide fixed, steady returns. However, credit risk varies widely; emerging market bonds typically offer higher yields but involve greater risk due to economic instability.

Characteristics of Bonds

Bonds have distinct features that set them apart in your investment toolkit.

• Each bond issuer promises regular interest payments, typically twice a year, providing investors steady income.
• Treasury bonds are especially attractive because their interest payments are exempt from state and local taxes.
• The value of the bond fluctuates based on interest rates and issuer credibility, impacting your bond portfolio.
• Bonds also have a fixed maturity date, offering predictability, and credit ratings, helping investors quickly gauge risks.

Understanding these characteristics helps you pick bonds matching your risk and return expectations.

Bond terms to know

Knowing bond jargon can help you confidently navigate investment decisions. Here are key terms simplified.

• Face Value: The original amount loaned to the bond issuer, repaid when the bond matures.
• Maturity Date: When the issuer repays the bond’s face value.
• Bond Issuer: The government, municipality, or company borrowing your money by selling bonds.
• Yield: Annual return based on current bond price. Credit Rating: Score indicating the issuer’s reliability to repay.
• Default Risk: The Chance that the issuer can't make promised payments, leading to potential losses.
• Municipal Bonds: Bonds issued by local governments; interest is typically exempt from federal income tax.
• Investment grade bonds: Bonds issued by governments or companies that have a high credit rating, indicating low risk of default.
• Revenue Bonds: Municipal bonds paid from specific project revenues.
• Agency Bonds: Bonds issued by government-sponsored entities.
• Treasury Inflation Protected Securities: Bonds paying interest adjusted for inflation, protecting the bond's value.

Why buy bonds?

Bonds might seem less exciting than stocks, but they offer unique benefits that make them essential in your investment portfolio.

Interest

One major reason investors love bonds is the steady interest payments. Think of it like getting regular checks from the issuer for lending them your money. Bonds typically pay interest twice a year, providing predictable income that can help fund your retirement or cover ongoing expenses. Unlike dividends from stocks, bond interest rates are usually fixed, offering reliability.

The role of bonds in a portfolio

Bond investing is also important in balancing your investment portfolio. Since they generally move differently from stocks, bonds can smooth out market ups and downs, protecting your overall wealth from big swings.

Types of Bonds

Below are the main types of bonds offered on various markets.

Government Bonds

Mutual funds or ETFs called "government bond funds" invest in debt securities issued by the federal government of the United States and its departments. Short-term government funds, like short-term CDs, don't expose you to a lot of danger when interest rates climb, as they did in 2022.

Who Are They Good for?

The funds make investments in US government debt and securities backed by mortgages that are issued by government-sponsored enterprises (GSEs). For low-risk investors, these government bond ETFs are ideal. For new investors and those seeking cash flow, these funds can also be a viable option. For risk-averse investors, bond funds might be a good option; however, some of them – like long-term ones – might vary significantly more than short-term funds as a result of interest rate changes.

Risks

Existing bond prices decrease when interest rates are higher and increase when interest rates are lower. However, long-term bonds are more susceptible to interest rate risk than short-term bonds. Growing rates won't have much of an effect on short-term bond funds, and the funds will gradually raise their interest rates in response to rising market rates. You can lose buying power if the interest rate can't keep up with high inflation.

Rewards

Thanks to these bonds' credit guarantee from the US government, funds that invest in government debt instruments are regarded as among the safest financial assets. Bond funds distribute their money every month, and with rates expected to soar higher in 2022, these funds will distribute far more money than they have in recent years.

Corporate Bonds

Bonds, which can be packed into funds and held by bonds issued by potentially hundreds of firms, are a common way for corporations to acquire capital from investors. With an average duration of one to five years, short-term bonds are less prone to interest rate changes than intermediate- or long-term bonds.

Who Are They Good for?

Investors seeking cash flow, such as retirees or those wishing to lower overall portfolio risk while still earning a return, should strongly consider corporate funds. Risk-averse investors looking for a little bit higher yield than government funds may benefit from short-term corporate bond funds.

Risks

Short-term corporate bond funds are not covered by the FDIC, as is the case with other bond funds.

There is a possibility that a company's credit rating will be lowered or that it will experience financial difficulties and issue bonds that will not be repaid. Make sure your fund consists solely of top-notch corporate bonds to minimize that danger.

Rewards

Compared to government and municipal bond funds, investment-grade short-term ones can provide investors with higher returns. However, higher profits come with more risk.

How are Bonds Priced?

Bond prices fluctuate daily based on supply and demand, just like any other traded security. While bonds can be held to maturity to receive full principal and interest, they are often bought and sold on the open bond market, where prices shift.

Assume that the rate on a short-term government bond determines the current interest rates to be 10% at the time that bond is issued. Given that both bonds would earn a $100 return, an investor would not care whether they choose to invest in a corporate or a government bond. Imagine, however, that a short while later, the economy has deteriorated and interest rates have fallen to 5%. The investor can now only get $50 from the government bond, while the corporate bond would still give them $100.

The corporate bond is significantly more appealing as a result of this distinction. As a result, bond market participants will bid up the bond's price until it trades at a premium that equalizes the environment for interest rates at play; in this case, the bond will trade at $2,000, such that the $100 coupon reflects 5%. In a similar vein, if interest rates rose to 15%, an investor could receive $150 from the government bond rather than paying $1,000 to make merely $100. The price of this bond would be sold until it equalized the yields, in this example at a price of $666.67.

Examples of Bonds

A bond is a borrower's promise to repay the lender the principal plus interest. Bonds are issued by national and local governments as well as businesses. The interest rate (coupon), principal amount, and maturity vary based on the issuer’s and buyer’s goals. Many corporate bonds include features that affect their value, making comparisons tricky for non-professionals. Bonds can be traded before maturity and are often listed publicly, making them accessible through brokers.

Governments issue many bonds, while corporations typically purchase them via brokerages. If you're interested in investing, selecting the right broker is essential - resources like Investopedia can help you compare options.

Fixed-rate bonds pay a consistent portion of their face value, but their market price changes with interest rates. For example, a $1,000 bond with a 5% coupon pays $50 annually. If market rates drop to 4%, that bond becomes more valuable. Conversely, if rates rise to 6%, the bond prices generally fall until it offers a competitive yield.

What are the risks associated with bonds?

Bonds are known as safer fixed income investments, but they're not without risks.

Interest rate risk

When rising interest rates hit the bond market, the value of existing bonds can drop. This happens because investors can now earn higher returns from other bonds issued at newer, higher rates, causing the older bonds you hold to lose appeal. If you sell early, you might miss out on potential capital gains or even take a loss.

Credit risk

Also known as default risk, credit risk refers to the chance the issuer can’t pay back what they've borrowed. Even investment-grade bonds, those considered relatively safe, aren’t immune. Companies or governments issue bonds to raise money, but financial trouble can impact their ability to pay you back.

Inflation risk

Inflation erodes the buying power of fixed interest payments. If inflation rises faster than your returns, your investment effectively loses value, limiting your purchasing power.

How can I buy bonds?

Buying bonds can diversify your portfolio and offer steady income. Here's how you can invest.

From a broker

You can buy or sell bonds and individual debt securities in general directly from an online broker, like J2T. Brokers offer government securities, corporate bonds, junk bonds, and other bonds with different face values. Keep in mind callable bonds, default risk, currency risk, and the impact of local taxes on capital gains. For currency management solutions, explore Forex services.

Via a mutual fund or ETF

Buying bonds through mutual funds or ETFs is another way of investing. Funds pool money to raise money collectively, offering instant diversification and professional management to reduce risk.

The Bottom Line

Bonds are essential debt securities for diversifying your investment strategy, offering income and relative stability compared to stocks. They're loans you provide to governments or companies, earning you regular interest payments until maturity.

While bonds carry risks like interest rate fluctuations, inflation, and potential issuer default, understanding their unique characteristics and types helps balance your portfolio effectively. Whether you buy individual bonds from brokers or invest through mutual funds or ETFs, bonds remain a smart choice for managing risk and achieving financial goals.

FAQ

What is a bond?

Governments and businesses issue bonds when they need to raise money. By purchasing a bond, you are effectively lending the issuer money. In exchange, they commit to repay you the face amount of the loan on a particular date and to make periodic interest payments – typically twice a year – along the way.

What is an example of a bond?

Some examples of bonds include treasuries, which are the safest bonds but have low-interest rates and are typically sold at auction, treasury bills, treasury notes, savings bonds, junk bonds, agency bonds, investment grade bonds, municipal bonds, and corporate bonds (which can be among the riskiest, depending on the company).

What is in a bond?

A bond is a fixed-income investment that simulates a loan from an investor to a borrower (typically corporate or governmental). A bond might be compared to an agreement outlining the terms of the loan and the associated payments between the lender and borrower.

What are the types of bonds?

Bonds generally fall into four categories: corporate bonds, municipal bonds, government bonds, and agency bonds.