Bond Investing Basics

Bonds are loans made by investors to governments, companies or other entities. When you buy a bond, you are lending money in exchange for regular interest payments and the promise of getting your principal back at a specified maturity date.

Many investors use bonds to balance the ups and downs of stocks, generate income, or match future liabilities such as tuition or retirement spending. This page covers the essentials: how bonds are structured, how yields work, the major types of bonds and the key risks to understand before investing.

Basic structure of a bond

Most plain-vanilla bonds share a few key features:

• Face value (par): the amount that will be repaid at maturity, often $1,000.
• Coupon rate: the interest rate paid on the face value (for example, 4% per year).
• Coupon payments: the schedule of payments, often semi-annual.
• Maturity date: when the issuer must repay the face value to investors.
• Issuer: the government, company or agency that promises to make payments.

After a bond is issued, it can trade in the secondary market. Its price will move up and down as interest rates, credit conditions and investor demand change.

Yield and price: the see-saw relationship

One of the most important ideas in bond investing is the relationship between price and yield. When market interest rates rise, existing bond prices generally fall. When rates fall, existing bond prices tend to rise.

Imagine a bond with a 3% coupon issued when market rates are also around 3%. If new bonds later start offering 5%, investors will not pay full price for the older 3% bond. Its price must drop until its effective yield is competitive with new issues. The opposite happens if rates fall below the bond's coupon.

Because of this, bond investors pay attention not just to the coupon printed on the bond, but to the yield to maturity (YTM) – a measure that combines price, coupon payments and time remaining until maturity.

Main types of bonds

There are many different bonds, but several broad categories are especially common:

• Government bonds: issued by national governments. In many countries, these are considered low credit risk when issued in the local currency.
• Investment-grade corporate bonds: issued by financially strong companies. They typically pay more interest than government bonds to compensate for extra risk.
• High-yield (junk) bonds: issued by companies with weaker credit ratings. They offer higher yields but come with a greater risk of default.
• Municipal or provincial bonds: issued by local governments or agencies, sometimes with tax advantages for local investors.
• Inflation-linked bonds: such as TIPS in the U.S., where payments adjust with an inflation index.

Key risks in bond investing

Bonds are often described as “safer” than stocks, but that does not mean they are risk-free. Major risks include:

• Interest-rate risk: the risk that rising rates will reduce the market value of existing bonds.
• Credit risk: the risk that the issuer will miss payments or default.
• Reinvestment risk: the risk that coupons will be reinvested at lower rates than the original bond.
• Inflation risk: the risk that inflation will erode the real value of future interest and principal payments.

Individual bonds vs. bond funds

Investors can hold bonds in two main ways:

• Individual bonds: buying specific issues and holding them to maturity. This offers control over cash flows and maturities, but requires more research and larger amounts of capital to diversify.
• Bond mutual funds or ETFs: funds that hold many bonds and trade like other pooled investments. These provide diversification and professional management, but their prices fluctuate with the market and there is no fixed maturity date for the fund.

Many investors use bond funds inside retirement accounts or broad asset-allocation strategies, while others prefer a ladder of individual bonds that mature at different times.

Where bonds fit in a portfolio

In a mixed portfolio of stocks and bonds, the bond allocation is often used to:

• Reduce overall volatility.
• Provide a stream of interest income.
• Create “dry powder” that can be reallocated during market downturns.
• Match known future spending needs.

Younger investors with a long time horizon may hold a smaller percentage in bonds, focusing more on growth assets. Those closer to retirement often increase their bond allocation to reduce the impact of stock market swings.

Questions to ask before buying bonds or bond funds

• What is the credit quality of the issuer or the average rating in the fund?
• What is the duration (a measure of interest-rate sensitivity)?
• How does the yield compare to similar alternatives?
• Are there any embedded options, such as the issuer's right to call the bond early?
• What fees apply if I use a bond fund instead of individual bonds?

To see how bonds interact with other investments, you may also want to read about mutual funds, forex, options and futures.