What are Bonds?
A bond is a fixed-income security in which an investor loans money to a government or corporation, which pays regular interest in return and repays the principal amount when the bond matures.
A bond is a type of fixed-income investment in which an investor lends money to a borrower — typically a government or corporation — in exchange for regular interest payments over a set period of time, plus the return of the original principal when the bond matures. Bonds are one of the two major building blocks of investment portfolios alongside stocks.
When you buy a bond, you become a creditor of the issuer, not a part-owner (as you would be when buying stock). In exchange for this loan, the issuer agrees to pay you a fixed rate of interest — called the coupon rate — at regular intervals (usually semi-annually), and to repay the face value (also called par value) of the bond at the maturity date.
Key Bond Terms
| Term | Definition |
|---|---|
| Par value | The face value of the bond, typically $1,000 |
| Coupon rate | The annual interest rate paid on the par value |
| Maturity date | When the issuer repays the principal |
| Yield to maturity (YTM) | Total expected return if held to maturity |
| Credit rating | An agency's assessment of the issuer's ability to repay |
Types of Bonds
U.S. Treasury bonds — Issued by the federal government; considered the safest bonds because they're backed by the full faith and credit of the U.S. government. Maturities range from short-term T-bills to 30-year Treasury bonds.
Municipal bonds ("munis") — Issued by state and local governments. Interest is often exempt from federal income tax and sometimes state tax, making them attractive to higher-income investors.
Corporate bonds — Issued by companies to fund operations or expansion. They pay higher interest rates than government bonds to compensate for higher default risk.
Series I Bonds — A special type of U.S. savings bond that adjusts its interest rate with inflation, protecting purchasing power.
Bond Prices and Interest Rates
This is the most important concept for bond investors: bond prices and interest rates move in opposite directions.
When interest rates rise:
- New bonds are issued at higher rates
- Existing bonds (paying lower rates) become less attractive
- The price of existing bonds falls
When interest rates fall:
- Existing bonds (paying higher rates) become more valuable
- Bond prices rise
This inverse relationship means that even "safe" bonds can lose market value in a rising rate environment. However, if you hold a bond to maturity, you will always receive the par value back (assuming no default).
The Role of Bonds in a Portfolio
Bonds serve several important functions in a diversified portfolio:
- Stability — Bonds typically fluctuate less than stocks and often rise in value when stock markets fall
- Income — Regular coupon payments provide predictable cash flow
- Asset allocation — Adding bonds to a stock portfolio reduces overall volatility; the right mix depends on time horizon and risk tolerance
- Recession protection — During economic downturns, investors often flee to bonds, driving their prices up
The traditional 60/40 portfolio (60% stocks, 40% bonds) has been a foundational model in long-term investing, though the optimal allocation shifts based on interest rate environments and individual circumstances.