What Are Bonds?
A bond is essentially a loan you make to a government, municipality, or corporation. In exchange, the borrower promises to pay you a fixed interest rate (called the coupon) over a specified period and return your principal at maturity. This is why bonds are called fixed income investments.
Unlike stocks, which represent ownership, bonds represent debt. When you buy a bond, you're a creditor, not an owner. This fundamental difference gives bonds their unique risk and return characteristics, making them essential to understanding bond investment basics.
"Bonds are the shock absorbers in your investment portfolio." — Burton Malkiel
How Do Bonds Work?
Understanding the mechanics of bonds is crucial for fixed income investment basics:
- Face Value (Par): The amount paid back at maturity, typically $1,000 per bond
- Coupon Rate: The annual interest rate paid on the face value
- Maturity Date: When the principal is returned to the investor
- Market Price: What the bond trades for in the secondary market
- Yield: The actual return considering the price paid and interest received
Types of Bonds
Treasury Bonds
Issued by the U.S. government, Treasury bonds are considered the safest investments available. They're backed by the "full faith and credit" of the U.S. government. Treasury securities include:
- T-Bills: Short-term (4-52 weeks), sold at discount
- T-Notes: Medium-term (2-10 years), pay semiannual interest
- T-Bonds: Long-term (20-30 years), pay semiannual interest
- TIPS: Treasury Inflation-Protected Securities, adjusted for inflation
Corporate Bonds
Issued by companies to raise capital. They offer higher yields than government bonds but carry more risk. Corporate bonds are rated by agencies like Moody's and S&P:
- Investment Grade: BBB or higher, lower risk
- High-Yield (Junk) Bonds: Below BBB, higher risk but higher returns
Municipal Bonds
Issued by state and local governments. A key advantage: interest is often exempt from federal taxes and sometimes state taxes. Types include:
- General Obligation Bonds: Backed by taxing power
- Revenue Bonds: Backed by specific project income
Understanding Bond Prices and Yields
Bond prices and yields have an inverse relationship—when one goes up, the other goes down. This is fundamental to bond investment basics:
When interest rates rise, existing bonds with lower rates become less attractive, so their prices fall. Conversely, when rates fall, existing bonds with higher rates become more valuable, pushing prices up.
Yield to Maturity (YTM)
YTM is the total return anticipated if the bond is held until maturity. It considers the current market price, face value, coupon payments, and time to maturity. This is the most comprehensive measure of a bond's return.
Why Include Bonds in Your Portfolio?
- Income Generation: Regular coupon payments provide steady cash flow
- Capital Preservation: Less volatile than stocks, helping protect principal
- Diversification: Bonds often move differently than stocks
- Deflation Protection: Fixed payments become more valuable when prices fall
- Portfolio Rebalancing: Stable returns allow for strategic rebalancing
Bond Risks to Consider
- Interest Rate Risk: Prices fall when rates rise (longer-term bonds affected more)
- Credit Risk: Issuer may default on payments
- Inflation Risk: Fixed payments lose purchasing power over time
- Reinvestment Risk: May not be able to reinvest at same rates
- Liquidity Risk: Some bonds hard to sell quickly
How to Invest in Bonds
Individual Bonds
Buy directly through brokers or TreasuryDirect.gov for government securities. Requires larger capital and more research but offers precise control over holdings.
Bond Funds and ETFs
Mutual funds and ETFs provide diversification across many bonds with lower minimums. Popular options include total bond market funds, short-term bond funds, and high-yield bond funds.
Bond Laddering
A strategy where you buy bonds with staggered maturities. As each bond matures, reinvest in a new long-term bond. This provides regular liquidity while capturing higher long-term rates.
The Role of Bonds at Different Life Stages
The traditional advice is to increase bond allocation as you age. Common rules of thumb:
- 20s-30s: 10-20% bonds for growth focus
- 40s-50s: 30-40% bonds for balance
- 60s+: 50-70% bonds for capital preservation
However, with longer lifespans and lower interest rates, many advisors now recommend maintaining higher stock allocations longer.