What is a bond?

Main roles

The issuer of a bond can be a company, government or other agency that is seeking to raise money, either to finance a specific project, bankroll its day-to-day operations, or refinance earlier debt. The buyer of a bond (playing the role of creditor) can usually be any investor, including private individuals, investment funds or banks.

Bonds can be bought from the issuer when it first puts them on the market to raise funds – this is called the primary market. These can be limited competitive auctions aimed at institutional investors; or, as an individual investor, you may simply buy new bonds via a broker or even from the issuer (such as the US government) directly. Once an investor buys a bond, they can either hold it until it matures; alternatively, they may later resell it to other investors, typically via a brokerage. This is called the secondary market, where the vast majority of market transactions involving bonds takes place. Here, bonds behave just like any other tradable security with a market value, and their resale no longer generates any funds for the issuer.

Bonds – how they are different from loans and stocks

Why would a government or a company raise funds via bonds rather than simply take out a bank loan? One difference between a loan and a bond is that attracting thousands of bondholders allows issuers to raise more money than what a bank may be willing or able to lend in a single transaction. Bonds typically carry lower interest rates than bank loans, lowering financing costs for the issuer. Finally, a bank loan often involves repaying both interest and principal throughout the loan duration; whereas in the case of bonds, the issuer only has to repay the principal in full upon maturity, allowing it more flexibility to use funds.

And what is the difference between bonds and stocks? Unlike stocks, bonds – let's focus on corporate bonds for a moment – don't grant you ownership of a company and therefore don't make you eligible for dividend payments and don't allow you to take part and vote in shareholder meetings. While the market value of stocks and corporate bonds both reflect the performance of the company and the general state of the economy, bonds tend to be less volatile than stocks. With lower risk come lower rewards: over the long run, the return on bonds is usually lower than on stocks. Speaking of risks: if an issuing company goes bankrupt, bondholders are often ranked ahead of stockholders when it comes to compensation claims. However, this depends on the regulations of the company's home country; please check this information carefully before investing.

Also interested in the stock market? Check out our handy guide on how to buy shares.

If you want to understand what a bond is and how it works, it's a good idea to first go over some of the key terms associated with bonds.

Main features

Principal

The principal is the face value of the bond; the amount that you are lending to the issuer and which you are due to receive back when the bond matures. The face value is set by the issuer, and can vary in size; for example, U.S. Treasury notes, a popular government bond, are sold in increments of $100.

Coupon

The coupon or coupon rate is basically the interest on the bond. For example, a $100 bond with a $5 annual coupon means you are eligible for an annual interest payment of $5. The term comes from a time when paper bonds were still the norm, and you had to detach coupons from the bond manually to be able to claim your interest payment. Bonds are now usually issued electronically and coupon payment is automatic.

Maturity

Maturity is the date when the repayment of the principal is due; it can also refer to the time elapsed between the bond issue and its maturity date, as in a ten-year bond. Maturity can range from a few weeks to as much as 100 years; maturities of one to ten years would be the most common for both corporate and government bonds.

Credit quality

Credit quality (also known as credit rating or bond rating) is a metric that shows whether an issuer is likely to have problems repaying the principal or meeting regular coupon payment obligations. Bonds or issuers with a high rating are very unlikely to default, while those with a lower rating are considered more risky. Bonds by lower-rated issuers normally have a higher coupon rate, in order to attract investors and compensate for higher risk.

Price vs yield

Market price

Similarly to all traded instruments, bonds have a market price on the secondary market that may be different from their face value. If a bond becomes less attractive (e.g. if new risks emerge regarding the issuer, or if new, higher-paying bonds hit the market), its price will fall. Conversely, the market price of a bond may rise if the credit rating of the issuer improves or if interest rates across the economy fall.

If a bond is trading at its face value on the secondary market, it is said to be trading at par. Similarly, a bond can trade at a discount (i.e. below face value, also commonly expressed in terms such as "90 cents on the dollar"), or at a premium, meaning above face value.

Yield

Closely tied to the market price is the concept of yield. In its simplest form, the bond yield is its annual coupon payment divided by the market price. For example, if you bought a $100 face-value bond with a $5 coupon for $95 on the secondary market, your yield will be 5 divided by 95, or 5.26%. So if the price of a bond goes down, its yield goes up, and vice versa. Compared with the coupon rate, the yield shows a more accurate picture of the actual return on your investment into a particular bond. More sophisticated calculations of the bond yield or the market price also involve the time left to maturity, or interest accrued since the last coupon payment period.

Real yield is yield adjusted for inflation. It is an important metric for buy-and-hold investors who use coupon payments as a source of income. The real yield can turn negative if inflation exceeds the bond yield.

The basic concept of a bond is relatively simple, but the variety of bond types can still be perplexing. What is a junk bond? What is a zero-coupon bond? We'll answer those questions here.

Based on issuer

The easiest way to categorize bonds is by issuer.

Government bonds

Government bonds are issued by national governments to help finance public spending. Although tax revenue forms the backbone of government budgets, all governments issue bonds either to make up for budget deficits, maintain a safety buffer, or repay maturing earlier debt. Governments usually issue bonds in the country's own currency. If you buy bonds issued by a foreign country, you may run a foreign exchange risk. To attract foreign buyers concerned about this risk, countries sometimes issue bonds in popular global currencies such as the US dollar or the euro.

Government bonds in the US are called Treasurys, of which there are four major types:

• Treasury bills, or T-bills, mature in one year or less; the shortest available maturity is four weeks.
• T-notes are available in maturities of 2, 3, 5, 7 and 10 years, and have a coupon payment every six months.
• T-bonds mature in 30 years, and also come with semi-annual coupon payment.
• Treasury Inflation-Protected Securities (TIPS) are bonds whose principal is periodically adjusted for inflation.

US Treasurys are backed by the "full faith and credit" of the US government. This, and a strong repayment record, make Treasurys among the safest investments anywhere.

Government bonds in different countries have different names and available maturities. For example, UK government bonds are called gilts, and the local equivalent of TIPS are called index-linked gilts. German government bonds are collectively called Bunds, ranging from six-month Bubills through five-year Bobls to 10- or 30-year Bunds, among others.

Municipal bonds

Municipal bonds are issued by cities, counties, or other tiers of local government. They work on a very similar principle to government bonds, and are used by the issuer to fund general spending or specific projects such as new roads or schools. Similarly to sovereign countries or corporations, municipal governments also often have a credit rating assigned by the big rating agencies, helping you judge the level of risk involved in buying their bonds.

Corporate bonds

Corporate bonds are issued by businesses, often to raise funds for new facilities or acquisitions. For the company, bonds are an alternative to issuing new stocks or taking out a bank loan. Corporate bonds are in general somewhat more risky than government bonds, because unlike governments, corporations can't simply raise taxes to meet bond obligations. Their only source for repaying principal and interest is their cash flow, which may fluctuate heavily depending on the company's business performance or the state of the industry it is operating in. To compensate for this higher risk, corporate bonds often pay higher returns than government bonds.

Based on yield type

Fixed-rate bonds

Bonds also differ according to how their coupon rate is calculated. Fixed-rate bonds are the most common type. These carry a coupon that is fixed as a percentage of the principal (e.g. a 5% annual coupon) for the entire duration of the bond.

Floating-rate bonds

Floating-rate bonds have a variable coupon rate that is tied to a benchmark rate, usually a short-term market rate such as the US Fed funds rate, Libor or Euribor. The coupon of a floating-rate bond may look something like 3-month USD Libor + 0.50%. Floating rates provide some protection against interest-rate fluctuations on the market.

Zero-coupon bonds

Zero-coupon bonds (sometimes called discount bonds) have no coupons and therefore make no periodic interest payments. Instead, they are sold by the issuer at a discount, and repay the face value at maturity. For example, you may buy a one-year zero-coupon bond with $100 face value for $95, and redeem $100 upon maturity; reaping an effective return of $5. US Treasury bills are the best-known example of a zero-coupon bond.

Other bond types and classifications

Below are some other bond types and common definitions you may come across as you explore the bond market.

Secured and unsecured bonds

Secured bonds are backed by some form of collateral, such as property, or a revenue stream from a project that was financed via the bond (such as a toll road). If the issuer defaults on interest or principal payments, bond buyers may lay claim to that collateral, mitigating their loss. By contrast, unsecured bonds are backed by no collateral. Unsecured bonds aren't necessarily risky – e.g. most government bonds are, technically speaking, unsecured – but they don't offer that added layer of protection in case of a default.

Junk bonds

Junk bonds (also referred to as high-yield bonds) are bonds that have a high risk of default and therefore offer higher-than-usual yields. A commonly accepted definition of a junk bond is a bond rated as "speculative" by one of the big rating agencies. For example, this would be a rating of BB or below at S&P; see a rundown of rating categories here. Junk bonds are typically issued by companies or governments that are facing – or have a recent history of – financial difficulties.

Subordinated bonds

Subordinated bonds are bonds that rank lower for purposes of compensation if the bond issuer goes into liquidation or bankruptcy. In such cases, assets of the bankrupt bond issuer company are sold off; proceeds are then used to first pay off holders of unsubordinated debt (also called senior debt), followed by holders of subordinated debt.

Covered bonds

Covered bonds are usually issued by financial institutions such as banks. They are essentially corporate bonds that are backed by assets held by that financial institution (such as mortgages or other loans or cash-producing investments) as collateral. Covered bonds are popular especially in Europe.

Convertible bonds, preferred stock

Convertible bonds are corporate bonds that may be converted to stocks in the issuing company at a pre-defined conversion rate. Convertible bonds allow you to take advantage of a rising share price while enjoying the relative security of a bond. On the downside, convertible bonds have a lower coupon rate than regular corporate bonds, leaving you with relatively poor returns if the share price fails to rise sufficiently to make a conversion worthwhile. In addition, gains that can be achieved via conversion are often capped.

Preferred stock in a company are special shares whose features make it something of a hybrid between bonds and common stock. They often pay higher and more frequent dividends than common stock, and are ranked ahead of common stock (but behind bonds) when it comes to claims on the company's assets in the case of liquidation. However, preferred stock have limited or no voting rights in the company, another feature making them more similar to bonds. Like bonds, preferred stocks are rated by credit rating agencies; because of the higher risk, they are usually rated lower than bonds issued by the same company.

Perpetual bond

A perpetual bond is a bond that has no maturity date. This means that the principal cannot be redeemed, and that the bond pays annual interest forever. In practice, issuers usually have the option to prematurely repay (or "call") the bond, often to lower financing costs in a falling interest-rate environment.

Inflation-indexed bonds

Inflation-indexed bonds (usually issued by governments) are designed to protect investors against the devaluation of their principal as a result of inflation. The principal is adjusted regularly (often daily) in line with an official inflation index. Coupon payments, expressed as a percentage of the principal, will also reflect inflation as a result.

Put bonds

Put bonds (or puttable bonds) are bonds that allow you to demand repayment of the principal ahead of maturity. This feature is useful if interest rates rise and you don't want to get stuck for years with a bond that pays low interest. This put option may only be exercised at certain dates, laid out in the bond prospectus at the time of issue.

Asset-backed securities

Asset-backed securities are bond-like instruments that are backed by collateral composed of various underlying assets such as home loans, car loans, credit card debt, or any other cash-producing asset, such as royalty payments. These individual assets are packaged (or "securitized") by special investment firms and then sold to investors. Based on the underlying assets, types of asset-backed securities include mortgage-backed securities (MBS), collateralized mortgage obligations (CMO), or collateralized debt obligations (CDO), among others.

Savings bonds

Savings bonds (specifically, US savings bonds) are US government bonds aimed at individual investors. Savings bonds do not have a secondary market. They also do not pay regular interest; instead, interest is periodically compounded and added to the principal, and is paid out along with the principal when the bond is redeemed. US savings bonds offer low returns, but are considered low risk, and gains are exempt from most taxes.

War bonds, bearer bonds

An early version of savings bonds were war bonds, issued by many countries to fund their governments' war efforts. War bonds were most widely used in Word War I and World War II. These bonds typically offered lower returns than other government bonds, and often appealed to buyers' patriotism.

Another historical term is bearer bonds – these are paper bonds that come with detachable coupons that can be used to redeem regular interest payment. Bearer bonds are unregistered, meaning that whoever presents the bond or its coupons is presumed to be the owner. This often led to abuse; which, along with the onset of computerized bond sales and registration, has made bearer bonds all but extinct.

Climate bonds, social impact bonds

Among more modern solutions, climate bonds are issued by governments, banks or corporations to raise funds for projects to combat climate change. These may include renewable energy projects, reforestation, urban mass transit systems, or energy efficiency programs. Aside from their purpose, climate bonds (also called green bonds) work just like conventional bonds, involving regular interest payments to investors and a pledge to repay principal when the bond matures.

Social impact bonds are also a relatively new phenomenon. They are typically issued by the public sector to socially conscious institutional or individual investors, and are used to fund various social projects. However, social impact bonds often only pay returns if certain social goals are met, meaning that they may be more risky and that it's difficult to apply conventional bond valuation methods.

Now that you understand what a bond is, let's take the next step and see how you can benefit from buying bonds. Bonds can play an important role in your investment portfolio, regardless of your investing strategies. Bonds are often favored by buy-and-hold investors or those getting close to retirement, who value relative safety and price stability and are content with lower returns than what stocks may offer over the long term. Bonds are also a key component of the investment portfolios of pension funds and life insurance providers, among others.

There are two basic approaches to buying bonds. As a bond investor, you would buy a bond and hold it to maturity, collecting regular coupon payments as a source of supplemental income. By contrast, in the role of a bond trader, you would buy and sell bonds on the secondary market, looking to benefit from increases in the market price of your bonds. Of course, you can play both roles at the same time; or even apply both strategies to the same bond – i.e. holding it for several years to collect regular interest, then selling it on the secondary market if the price is right or if you need to cash in for any reason.

Buying bonds

How to buy bonds? The easiest and best way to buy bonds is from an online broker. Here, you will mostly participate in the secondary market, buying bonds at various stages toward their maturity that have been sold by other investors. Another, indirect way to tap into bond markets is to invest in bond-focused mutual funds or bond ETFs (exchange traded funds). These funds invest into a diversified portfolio of bonds and are managed by professionals; though fees may be high. Many online brokers offer mutual funds and bond ETFs in addition to individual bonds.

In some cases it's possible to buy bonds directly from the issuer. The best-known example of this is the US Savings Bond, which can be purchased directly from the TreasuryDirect service of the US government.

How to redeem Savings Bonds?

US Savings Bonds can be redeemed after 12 months at the earliest, though a penalty equal to three months' interest applies if you cash in savings bonds within five years of purchase. All interest is paid out upon redemption, and federal taxes (if applicable) are also levied at this point. Although US Savings Bonds do not technically mature, they stop paying interest after 30 years, and taxes are also applied at this point at the latest.

Things to watch when you compare brokers for bonds

When picking an online broker for your bond investments, these are the three most important factors to consider and compare, on top of general criteria like broker safety:

Bond fees

While trading fees are an important consideration for any asset class, it is especially crucial in the case of bonds. As bonds typically offer lower returns, even a seemingly small fee can amount to a visible portion of your gains.

Inactivity fee

Some brokers will start charging a fee if you haven't used your account for trading for a specified period of time (typically a few months). If you are a buy-and-hold bond investor, it's possible that once you have assembled a bond portfolio, you won't feel the need to trade again for a while. To avoid any penalties for this, it is best to choose a broker that charges no inactivity fee.

Bond selection

A wider bond selection, comprising both government and corporate bonds (including international ones), or even bond funds or bond ETFs, will give you a better chance of building a diverse portfolio, thereby balancing risks and optimizing returns.

Best brokers for bond trading

To help with your decision, whether you are focusing on the European or the US market, we picked the top brokers for bond trading based on the above criteria.

Bond indices, similarly to stock market indices such as the S&P500, are designed to measure and track the performance of a segment of the bond market. You can't invest in bond indices directly, but they can serve as a benchmark against which to gauge the performance of your own bond portfolio, and they can also give you an idea of whether the market is generally heading up or down.

There are literally thousands of bond indices out there, focusing on various segments of the bond market based on issuer (government or corporate), country, maturity, credit rating, underlying assets, or a combination of any of the above. So you may have indices for US high-yield corporate bonds, emerging-market inflation-linked bonds, or German short-term government bonds. Indices are calculated from the prices of a "basket" of bonds, using a weighted average based on issue size.

The most popular indices are compiled by major investment banks or specialized firms such as J.P. Morgan, Citi, S&P, FTSE, (Bank of America) Merrill Lynch, or Bloomberg/Barclays. Some examples include the Bloomberg Barclays US Aggregate Bond Index, the Citi World Government Bond Index, or the J.P. Morgan Emerging Markets Bond Index.

A bond rating is a score that describes the creditworthiness of a bond issuer, or that of an individual bond issue. In general, it assesses the likelihood that the issuer will be able to pay back principal and interest on its bonds in a timely manner.

Bond ratings are assigned by rating agencies. The three biggest rating agencies are Standard & Poor's (S&P), Moody's and Fitch. Ratings are assigned (or withdrawn) at the request of the issuers.

Rating categories explained

Bond ratings are similar to US-style school grades, going from variations of 'A' as the best grade to as low as 'D' meaning default. For example, the table below shows the rating tiers of S&P, from best to worst:

Issuers or bonds rated from AAA through BBB (long-term) are collectively called investment grade, and are viewed by the agency as having "extremely strong" to "adequate" capacity to meet financial obligations. Meanwhile, those BB and under are loosely referred to as non-investment grade, speculative, high-yield or, simply, junk. Issuers in the BB/B bracket can meet current obligations but may face uncertainties or adverse business conditions that could impair their ability to do so down the road; while those in the C's are viewed as vulnerable or highly vulnerable.

Ratings typically come up for a review several times a year, though actual changes to ratings are usually much less frequent. Grades come with an outlook score of positive, stable or negative, indicating the most likely direction of upcoming rating changes. For example, an issuer rated BBB+ with a positive outlook has a good chance of being upgraded to A- within the next year.

Bond ratings can significantly affect the outcome of a bond issue. Issuers with poor ratings have to offer high interest payments to attract investors. In addition, some investors, such as pension funds, may have limitations imposed on the amount of junk bonds they're allowed to hold in their portfolio.

The purpose of bond valuation is to calculate the fair value or "present value" of a bond – in other words, the price at which you should buy it if you want to achieve a specific return. Doing so requires a complex equation that calculates the expected cash flows of a bond (including the size and number of coupon payments, the time left to maturity, and the repayment of principal upon maturity), discounted by expected returns, also referred to as yield to maturity (YTM). These formulas may look intimidating, but apps offered by your broker's trading platform or online calculators will do the math for you.

Such calculations assume that you buy a bond just after the coupon payment date. This theoretical price is called the "clean price". In practice, you will more likely buy bonds between two coupon payments (let's say, two months into a six-month coupon payment period), in which case you must also add two months' worth of interest to arrive at the correct price you should pay for the bond – this is called the "dirty price".

In theory, real interest rates across the economy are the main driver of bond market prices. However, some market distortions exist, especially on government bond markets. Since the 2008 Great Financial Crisis and the 2011 Euro crisis, central banks of the US, the Eurozone and Japan often had monetary policies (e.g. Quantitative Easing) that resulted in the suppression of yields on bonds issued by these governments. Hence, it is quite common for instruments such as German or Swiss government bonds to have a negative yield. Debt issued by advanced economies often offers no real yield, i.e. yield adjusted for inflation.

📈 Are you worried about inflation and its potential impact on your investments? Our Inflation page is here to help! Learn how inflation can impact your investments and discover practical ways to protect them with our beginner's guide to inflation.

Bonds are generally viewed as a safe investment, but they are far from entirely risk-free. Below are some of the most common risks associated with bonds. Some of these, such as default risk or inflation risk, are more of a concern for bond investors (i.e. those who hold a bond until maturity); whereas other risk types such as downgrade risk, liquidity risk or interest-rate risk will only affect bond traders active on the secondary market.

For a more thorough explanation of market risk – not just for bonds – read our risk guide.

Credit/default risk

Credit or default risk is the risk that the issuer will become unable to meet payment obligations of principal and/or regular interest on a bond. This risk is reflected in the issuer's credit rating and, by extension, in the bond's interest rate.

Interest rate / market risk

If you're holding a bond with a fixed interest rate, the market value of the bond will fluctuate depending on interest rate levels across the economy; this is called interest rate or market risk. If interest rates rise, your bond's value will fall. This is because investors will be selling off these bonds on the secondary market in search of higher-paying bonds, creating an oversupply and pushing the price down. By the same token, if you want to sell your bond on the secondary market, you have to settle for a lower price – so that the bond's yield, which rises as its price falls, will match what the market demands.

Inflation risk

Rising inflation can be a threat to your returns if you're holding a bond with a fixed coupon rate. Let's say you buy a one-year bond with a 3% fixed rate. If inflation rises to 3%, your effective return will melt to zero; though you're still better off than not having invested your money at all. Inflation will also negatively affect the real value of the principal if you hold a bond until maturity. Furthermore, rising inflation usually brings about higher interest rates in the economy, exposing you to interest rate risk (see above). If you are concerned about inflation, consider investing in inflation-indexed bonds.

Liquidity risk

Liquidity risk is the possibility that, often for a limited time only, there simply aren't any buyers or sellers on the secondary market for the bond you intend to sell or buy. This may result in situations where you can't cash in on an investment exactly when you need the money; and when you can finally do so, market conditions (e.g. interest rates or the issuer's credit ratings) may have changed for the worse.

Reinvestment risk

Reinvestment risk is usually associated with callable bonds, when the issuer has the right to buy back, or "call" the bond ahead of maturity. If interest rates are lower at the time of the call than when you bought the bond (which is probably why the issuer chose to call the bond in the first place), you will only be able to reinvest your money at a lower rate.

Downgrade risk

Even if you buy a bond from an issuer with an excellent credit rating, it is never guaranteed that the rating will remain the same until the bond's maturity. Issuers – whether companies or governments – can be downgraded any time by credit rating agencies if their financial situation or creditworthiness deteriorates. If the issuer is downgraded, the value of your bond will fall, as demand for the bond by more risk-averse investors will drop, and those investors who are interested will demand a higher yield.

Foreign exchange risk

If you buy a bond in a different currency than your own, you will run a foreign exchange, or exchange-rate risk. For example, let's say you live in the US, and buy a euro-denominated government bond with a 3% coupon rate. If the euro weakens against the US dollar by 10%, the coupon payment will be worth only 2.7% of your original investment when converted back into US dollars. You are exposed to the same conversion loss if your bond matures or if you sell it on the secondary market. Of course, exchange rate movements can also work in your favor.