Key Takeaways
- A bond is a loan from you to a government or company that pays interest and returns your principal at maturity.
- Bond prices usually move in the opposite direction of interest rates.
- Bonds are generally less volatile than stocks but are not risk-free.
- Many investors use bond funds to add stability to a stock-heavy portfolio.
Stocks get most of the attention, but bonds are the other major building block of most portfolios. Understanding how they work helps you decide how much stability your investments need.
How a Bond Works
When you buy a bond, you are lending money to the issuer. In return, the issuer usually pays you interest, called the coupon, on a regular schedule, and repays the bond’s face value when it matures.
Key terms:
- Face value: the amount repaid at maturity, often $1,000 per bond.
- Coupon rate: the annual interest rate based on face value.
- Maturity: when the loan ends and principal is repaid.
- Yield: the return you earn based on the price you actually pay.
Types of Bonds
- U.S. Treasuries: issued by the federal government and considered very low credit risk.
- Municipal bonds: issued by states and cities; interest is often exempt from federal income tax.
- Corporate bonds: issued by companies; usually pay more than Treasuries to compensate for higher risk.
- High-yield bonds: corporate bonds with lower credit ratings and higher risk of default.
Why Bond Prices Change
If interest rates rise after you buy a bond, new bonds pay more, so your older, lower-paying bond becomes less attractive and its market price falls. If rates fall, your bond’s price tends to rise. Longer-term bonds are more sensitive to rate changes than short-term bonds.
If you hold an individual high-quality bond to maturity, you generally receive the full face value regardless of these price swings, as long as the issuer does not default.
The Main Risks
- Interest rate risk: prices fall when rates rise.
- Credit risk: the issuer may fail to pay.
- Inflation risk: fixed payments may lose purchasing power.
How Beginners Usually Own Bonds
Rather than buying individual bonds, most beginners use bond funds or ETFs, which hold hundreds of bonds and provide instant diversification. Target-date funds also include bonds automatically.
Example: Interest Payments and Price Changes
You buy a $1,000 bond with a 4% coupon. It pays you $40 a year until maturity, then returns your $1,000.
A year later, new bonds of the same quality pay 5%. To sell your 4% bond, you would likely have to accept less than $1,000, because buyers can get more interest elsewhere. If rates instead fell to 3%, your bond would likely be worth more than $1,000.
Examples are hypothetical and for illustration only. Returns are not guaranteed, and real results will vary.
Frequently Asked Questions
Are bonds safer than stocks?
High-quality bonds are generally less volatile than stocks, but they can still lose value, especially when interest rates rise.
How much of my portfolio should be in bonds?
It depends on your time horizon and risk tolerance. People close to needing their money often hold more bonds than younger investors.
What is a bond fund?
A fund that pools money to buy many bonds. Unlike an individual bond, it does not have a single maturity date, so its value keeps fluctuating with rates.
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