What is a bond?

What is a bond?

A bond is a loan you give to a government or a company. They pay interest on a set schedule and return your principal at maturity. You are the lender. They are the borrower. Your payment is the coupon.

Governments sell bonds to fund roads and schools. Companies sell them to grow without giving up ownership. New issues reach the primary market, where a syndicate of banks underwrites the issue and resells it to investors. A bond grants no ownership stake, and bondholders stand ahead of shareholders.

How does a bond pay you?

Every bond has a par value, the amount you get back at maturity, and a coupon, the rate it pays along the way. Most pay interest twice a year until maturity returns your principal.

The yield is your real return. When prices fall, yields rise. When prices rise, yields fall. Hold to the end and every coupon plus any price change gives you the yield to maturity. Plot yields across maturities and that line is the yield curve, the market's read on rates.

Why do bond prices move against interest rates?

Interest rate risk runs the other way. When interest rates rise, new bonds pay higher coupons. Your older bond loses its appeal, so its price falls until its yield matches the market. A $1,000 bond paying 5% sells for about $500 once new bonds pay 10%.

Hold that bond to maturity and you still get your $1,000 par value back. The loss only becomes real if you sell early. Duration tells you how much a bond's price moves for a 1% rate change, so long maturities swing far more than short ones.

What are the risks of bonds?

Default risk is the biggest. The borrower might not pay you back. A credit rating from S&P, Moody's, or Fitch grades that risk, from investment-grade issuers at the top down to junk.

Inflation risk is next. A bond pays a fixed amount years from now. If inflation eats away at that amount, your real return shrinks. TIPS and inflation-linked bonds adjust for inflation, so they protect what a fixed bond loses.

Call risk hits you when rates fall. The issuer calls the bond and repays you early, forcing you to reinvest at lower rates. Liquidity risk is the reverse: you cannot always find a buyer fast without taking a price cut.

What is a bond indenture and how does seniority work?

Every corporate issue is governed by an indenture, the formal debt agreement that sets its terms: the coupon, the maturity, and the collateral. Its covenants are the clauses, spelling out what the issuer must do and what it cannot, and what happens to bondholders if it breaks them.

Seniority decides who gets paid first in bankruptcy. Secured bonds are backed by specific assets a bondholder can claim. Unsecured bonds, including most corporate debt, have no such claim. Subordinated, or junior, bonds rank below everything else, so they pay higher yields and take deeper losses.

What are the main types of bonds?

Treasuries carry the full faith of the U.S. government and are seen as nearly risk-free. Bills run to a year, notes to ten, bonds to 30. Savings bonds are the retail cousin, bought directly, interest accruing until you cash them in.

Municipal bonds are the tax play: their interest is usually free of federal tax, and in-state munis escape state tax too. General obligation bonds are repaid from taxes, revenue bonds from fees. Tax-exempt interest can still trigger the alternative minimum tax, and a discounted muni's gain is taxed at sale.

Agency bonds, from government-sponsored firms like Fannie Mae and Freddie Mac, sit a rung riskier than Treasuries. Mortgage-backed securities bundle home loans and pass the payments through, with prepayment risk if owners refinance. Corporate bonds are the largest slice, from investment-grade down to high-yield.

Zero-coupon bonds sell at a discount and pay no interest. Treasury STRIPS split a note into principal and interest pieces. Callable bonds let the issuer repay early. Floating-rate coupons reset to a benchmark like SOFR. Convertible bonds turn into stock. International bonds pay in foreign currencies, adding currency risk.

How do you buy bonds?

Bonds trade on a secondary market, so your bond is negotiable: you can sell it before maturity. Each carries an ISIN, a code that identifies it. SIFMA sizes the global bond market near $130 trillion, larger than global stocks. Buy through most brokers, or Treasuries direct at TreasuryDirect.gov.

Most bonds trade over the counter, not on an exchange, so a dealer's markup or commission rides inside the price and often goes undisclosed. Buying between coupon dates also means paying the seller accrued interest, the interest built up since the last payment.

Bond funds and ETFs own a basket of bonds, spreading risk, but a fund has no set maturity. You cannot hold a fund to par, so waiting does not escape rate losses. Funds charge fees and track an index like the Bloomberg US Aggregate. Check yield to maturity first.

How do bonds fit into a long-term plan?

Bonds are the seatbelt in your car. Stocks are the engine. The seatbelt doesn't make you go faster, but it keeps you alive when the road gets rough. That is why bonds are called portfolio ballast.

The right mix depends on your age and goals. Early on, when you have decades, stocks carry the load. As you near retirement, you shift toward bonds to protect what you have. The older you get, the more bonds you hold.