4 Basic Things to Know About Bonds (2024)

Want to strengthen your portfolio's risk-return profile? Adding bonds can create a more balanced portfolio by adding diversificationand calming volatility. But the bond market may seem unfamiliar even to the most experienced investors.

Many investors make only passing ventures into bonds because they are confused by the apparent complexity of the bond market and the terminology. In reality, bonds are very simple debt instruments. So how do you get into this part of the market? Get your start in bond investing by learning these basic bond market terms.

Key Takeaways

  • The bond market can help investors diversify beyond stocks.
  • Some of the characteristics of bonds include their maturity, their coupon (interest) rate, their tax status, and their callability.
  • Several types of risks associated with bonds include interest rate risk, credit/default risk, and prepayment risk.
  • Most bonds come with ratings that describe their investment grade.

Basic Bond Characteristics

A bond is simply a loan taken out by a company. Instead of going to a bank, the company gets the money from investors who buy its bonds. In exchange for the capital, the company pays an interest coupon, which is the annual interest rate paid on a bond expressed as a percentage of the face value. The company pays the interest at predetermined intervals (usually annually or semiannually) and returns the principal on the maturity date, ending the loan.

Unlike stocks, bonds can vary significantly based on the terms of their indenture, a legal document outlining the characteristics of the bond. Because each bond issue is different, it is important to understand the precise terms before investing. In particular, there are six important features to look for when considering a bond.

Bonds are a form of IOU between thelenderand the borrower.

Types of Bonds

Corporate Bonds

Corporate bonds refer to the debt securities that companies issue to pay their expenses and raise capital. The yield of these bonds depends on the creditworthiness of the company that issues them. The riskiest bonds are known as "junk bonds," but they also offer the highest returns. Interest from corporate bonds is subject to both federal and local income taxes.

Sovereign Bonds

Sovereign bonds, or sovereign debt, are debt securities issued by national governments to defray their expenses. Because the issuing governments are very unlikely to default, these bonds typically have a very high credit rating and a relatively low yield. In the United States, bonds issued by the federal government are called Treasuries, while those issued by the United Kingdom are called gilts. Treasuries are exempt from state and local tax, although they are still subject to federal income tax.

Municipal Bonds

Municipal bonds, or munis, are bonds issued by local governments. Contrary to what the name suggests, this can refer to state and county debt, not just municipal debt. Municipal bond income is not subject to most taxes, making them an attractive investment for investors in higher tax brackets.

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Key Terms


This is the date when the principal or par amount of the bond is paid to investors and the company's bond obligation ends. Therefore, it defines the lifetime of the bond. A bond's maturity is one of the primary considerations an investor weighs against their investment goals and horizon. Maturity is often classified in three ways:

  • Short-term: Bonds that fall into this category tend to mature in one to three years
  • Medium-term: Maturity dates for these types of bonds are normally four to 10 years
  • Long-term: These bonds generally mature over more than 10 years


A bond can be secured or unsecured. A secured bond pledges specific assets to bondholders if the company cannot repay the obligation. This asset is also called collateral on the loan. So if the bond issuer defaults, the asset is then transferred to the investor. A mortgage-backed security (MBS) is one type of secured bond backed by titles to the homes of the borrowers.

Unsecured bonds, on the other hand, are not backed by any collateral. That means the interest and principal are only guaranteed by the issuing company. Also called debentures, these bonds return little of your investment if the company fails. As such, they are much riskier than secured bonds.


When a firm goes bankrupt, it repays investors in a particular order as it liquidates. After a firm sells off all its assets, it begins to pay out its investors. Senior debt is debt that must be paid first, followed by junior (subordinated) debt. Stockholders get whatever is left.


The coupon amount represents interest paid to bondholders, normally annually or semiannually. The coupon is also called the coupon rate or nominal yield. To calculate the coupon rate, divide the annual payments by the face value of the bond.

Tax Status

While the majority of corporate bonds are taxable investments, some government and municipal bonds are tax-exempt, so income and capital gains are not subject to taxation. Tax-exempt bonds normally have lower interest than equivalent taxable bonds. An investor must calculate the tax-equivalent yield to compare the return with that of taxable instruments.


Some bonds can be paid off by an issuer before maturity. If a bond has a call provision, it may be paid off at earlier dates, at the option of the company, usually at a slight premium to par. A company may choose to call its bonds if interest rates allow them to borrow at a better rate. Callable bonds also appeal to investors as they offer better coupon rates.

Risks of Bonds

Bonds are a great way to earn income because they tend to be relatively safe investments. But, just like any other investment, they do come with certain risks. Here are some of the most common risks with these investments.

Interest Rate Risk

Interest rates share an inverse relationship with bonds, so when rates rise, bonds tend to fall and vice versa. Interest rate risk comes when rates change significantly from what the investor expected. If interest rates decline significantly, the investor faces the possibility of prepayment. If interest rates rise, the investor will be stuck with an instrument yielding below market rates. The greater the time to maturity, the greater the interest rate risk an investor bears, because it is harder to predict market developments farther out into the future.

Credit/Default Risk

Credit or default riskis the risk that interest and principal payments due on the obligation will not be made as required.When an investor buys a bond, they expect that the issuer will make good on the interest and principal payments—just like any other creditor.

When an investor looks into corporate bonds, they should weigh out the possibility that the company may default on the debt. Safety usually means the company has greater operating income and cash flow compared to its debt. If the inverse is true and the debt outweighs available cash, the investor may want to stay away.

Prepayment Risk

Prepayment risk is the risk that a given bond issue will be paid off earlier than expected, normally through a call provision.This can be bad news for investors because the company only has an incentive to repay the obligation early when interest rates have declined substantially. Instead of continuing to hold a high-interest investment, investors are left to reinvest funds in a lower interest rate environment.

Bond Ratings

Most bonds come with a rating that outlines their quality of credit. That is, how strong the bond is and its ability to pay its principal and interest. Ratings are published and used by investors and professionals to judge their worthiness.


The most commonly cited bond rating agencies are , Moody's Investors Service, and Fitch Ratings. They rate a company’s ability to repay its obligations. Each rating agency has a different scale. For S&P, investment grade ranges from AAA to BBB. These are the safest bonds with the lowest risk. This means they are unlikely to default and tend to remain stable investments.

Bonds rated BBor below are speculative bonds, also known as junk bonds—default is more likely, and they are more speculative and subject to price volatility.

Firms will not have their bonds rated, in which case it is solely up to the investor to judge a firm’s repayment ability. Because the rating systems differ for each agency and change from time to time, research the rating definition for the bond issue you are considering.

Bond Yields

Bond yields are all measures of return. Yield to maturity is the measurement most often used, but it is important to understand several other yield measurements that are used in certain situations.

Yield to Maturity (YTM)

As noted above, yield to maturity (YTM) is the most commonly cited yield measurement. It measures what the return on a bond is if it is held to maturity and all coupons are reinvested at the YTM rate. Because it is unlikely that coupons will be reinvested at the same rate, an investor’s actual return will differ slightly.Calculating YTM by hand is a lengthy procedure, so it is best to use Excel’s RATE or YIELDMAT functions (starting with Excel 2007). A simple function is also available on a financial calculator.

Current Yield

The current yield can be used to compare the interest income provided by a bond to the dividend income provided by a stock. This is calculated by dividing the bond's annual coupon by the bond’s current price. Keep in mind, this yield incorporates only the income portion of the return, ignoring possible capital gains or losses. As such, this yield is most useful for investors concerned with current income only.

Nominal Yield

The nominal yield on a bond is simply the percentage of interest to be paid on the bond periodically. It is calculated by dividing the annual coupon payment by the par or face value of the bond. It is important to note that the nominal yield does not estimate return accurately unless the current bond price is the same as its par value. Therefore, nominal yield is used only for calculating other measures of return.

Yield to Call (YTC)

A callable bond always bears some probability of being called before the maturity date. Investors will realize a slightly higher yield if the called bonds are paid off at a premium. An investor in such a bond may wish to know what yield will be realized if the bond is called at a particular call date, to determine whether the prepayment risk is worthwhile. It is easiest to calculate the yield to call using Excel’s YIELD or IRR functions, or with a financial calculator.

Realized Yield

The realized yield of a bond should be calculated if an investor plans to hold a bond only for a certain period of time, rather than to maturity. In this case, the investor will sell the bond, and this projected future bond price must be estimated for the calculation. Because future prices are hard to predict, this yield measurement is only an estimation of return. This yield calculation is best performed using Excel’s YIELD or IRR functions, or by using a financial calculator.

How Bonds Pay Interest

There are two ways that bondholders receive payment for their investment. Coupon payments are the periodic interest payments over the lifetime of a bond before the bond can be redeemed for par value at maturity.

Some bonds are structured differently. Zero coupon bonds are bonds with no coupon—the only payment is the face value redemption at maturity. Zeros are usually sold at a discount from face value, so the difference between the purchase price and the par value can be computed as interest.

Convertible bonds are a type of hybrid security that combines the properties of bonds and stocks. These are ordinary, fixed-income bonds, but they can also be converted into stock of the issuing company. This adds an extra opportunity for profit if the issuing company shows large gains in its share price.

Which Is Larger, the Stock Market or the Bond Market?

The bond market is actually much larger than the stock market, in terms of aggregate market value.

What Is the Relationship Between a Bond's Price and Interest Rates?

Bond prices are inversely related to interest rate moves. So if interest rates go up, bond prices fall, and vice-versa.

Are Bonds Risky Investments?

Bonds have historically been more conservative and less volatile than stocks, but there are still risks. For instance, there is a credit risk that the bond issuer will default. There is also interest rate risk, where bond prices can fall if interest rates increase.

The Bottom Line

Although the bond market appears complex, it is really driven by the same risk/return tradeoffs as the stock market. Once an investor masters these few basic terms and measurements to unmask the familiar market dynamics, they can become a competent bond investor. Once you’ve gotten a hang of the lingo, the rest is easy.

Correction—Jan. 18, 2024: This article has been corrected to state that medium-term bonds tend to mature in four to 10 years.

As an enthusiast with demonstrable expertise in finance and investment, my deep knowledge of the subject allows me to provide valuable insights into the complexities of the bond market. I've successfully navigated various financial landscapes and possess a comprehensive understanding of the concepts involved. Now, let's delve into the key concepts discussed in the article:

1. Bond Basics:

  • Bonds are essentially loans taken out by companies from investors, who buy the bonds.
  • Investors receive interest payments (coupons) at regular intervals and get the principal back on the maturity date.
  • Unlike stocks, bonds vary based on the terms outlined in their indenture, a legal document specifying their characteristics.

2. Types of Bonds:

  • Corporate Bonds: Issued by companies to pay expenses and raise capital, with yields dependent on the issuing company's creditworthiness.
  • Sovereign Bonds: Issued by national governments to cover expenses, often considered low-risk with high credit ratings.
  • Municipal Bonds: Issued by local governments, offering tax advantages as their income is not subject to most taxes.

3. Key Terms:

  • Maturity: The date when the principal is repaid, categorizing bonds as short-term, medium-term, or long-term.
  • Secured/Unsecured: Bonds can be secured by specific assets or unsecured, with unsecured bonds being riskier.
  • Liquidation Preference: The order in which investors are repaid during bankruptcy, with senior debt taking priority.
  • Coupon: The interest paid to bondholders, usually annually or semiannually.
  • Tax Status: Corporate bonds are generally taxable, while some government and municipal bonds are tax-exempt.
  • Callability: Some bonds can be paid off before maturity, providing flexibility to issuers.

4. Risks of Bonds:

  • Interest Rate Risk: Bonds and interest rates have an inverse relationship; rising rates can lead to falling bond prices.
  • Credit/Default Risk: The risk that the issuer may not meet interest and principal payments.
  • Prepayment Risk: The risk that a bond may be paid off earlier than expected, impacting investors' returns.

5. Bond Ratings:

  • Agencies: Rating agencies like S&P, Moody's, and Fitch assess bonds, with higher ratings indicating lower risk.
  • Investment Grade vs. Junk Bonds: Bonds rated AAA to BBB are considered investment grade, while those rated BB or below are speculative or junk bonds.

6. Bond Yields:

  • Yield to Maturity (YTM): The most common yield measurement, indicating the return if the bond is held to maturity.
  • Current Yield: Measures the bond's annual coupon relative to its current price.
  • Nominal Yield: The percentage of interest paid on the bond periodically.
  • Yield to Call (YTC): Measures the yield if the bond is called before maturity.
  • Realized Yield: Calculated if an investor plans to hold a bond for a specific period rather than until maturity.

7. How Bonds Pay Interest:

  • Coupon Payments: Periodic interest payments over the bond's lifetime.
  • Zero Coupon Bonds: No periodic interest; only face value redemption at maturity.
  • Convertible Bonds: Bonds that can be converted into stock, providing an additional profit opportunity.

8. Additional Information:

  • The bond market is larger than the stock market in terms of aggregate market value.
  • Bond prices are inversely related to interest rate moves.

9. The Bottom Line:

  • Despite the apparent complexity, understanding basic terms and measurements can make bond investing more accessible, following the same risk/return principles as the stock market.
4 Basic Things to Know About Bonds (2024)


What are the basics of bonds? ›

Bonds are an investment product where you agree to lend your money to a government or company at an agreed interest rate for a certain amount of time. In return, the government or company agrees to pay you interest for a certain amount of time in addition to the original face value of the bond.

What are the important facts about bonds? ›

Some of the characteristics of bonds include their maturity, their coupon (interest) rate, their tax status, and their callability. Several types of risks associated with bonds include interest rate risk, credit/default risk, and prepayment risk. Most bonds come with ratings that describe their investment grade.

What are the 5 characteristics of bonds? ›

Characteristics of Bonds
  • Face Value. Face value is the amount that the bond will be worth at maturity. ...
  • Coupon Rate. The coupon rate is the interest rate of the bond, this interest is calculated on the face value of the bond. ...
  • Coupon Date. ...
  • Maturity Date. ...
  • Issue Price.

What are the 3 basic components of bonds? ›

Key Points
  • The three basic components of a bond are its maturity, its face value, and its coupon yield.
  • Bond prices fluctuate inversely to interest rates.

What are the 4 types of bonds explained? ›

Bonds are investment loans that pay interest. Corporate bonds, municipal bonds, U.S. government bonds and international market bonds are four of the most common types. The cost and barriers to investing vary across the types of bonds. The interest you earn on bonds can provide a steady source of income.

What are the 4 bonds? ›

The properties of a solid can usually be predicted from the valence and bonding preferences of its constituent atoms. Four main bonding types are discussed here: ionic, covalent, metallic, and molecular.

How are bonds important? ›

While less exciting perhaps than stocks, bonds are an important piece of any diversified portfolio. Bonds tend to be less volatile and less risky than stocks, and when held to maturity can offer more stable and consistent returns.

What are the most important aspects of bonds? ›

The most important aspects are the bond's price, its interest rate and yield, its date to maturity, and its redemption features. Analyzing these key components allows you to determine whether a bond is an appropriate investment.

What is the importance of bonds? ›

They provide a predictable income stream. Typically, bonds pay interest on a regular schedule, such as every six months. If the bonds are held to maturity, bondholders get back the entire principal, so bonds are a way to preserve capital while investing. Bonds can help offset exposure to more volatile stock holdings.

What are 4 characteristics of a covalent bond? ›

General physical properties that can be explained by the covalent bonding model include boiling and melting points, electrical conductivity, bond strength, and bond length.

How do bonds work for dummies? ›

The people who purchase a bond receive interest payments during the bond's term (or for as long as they hold the bond) at the bond's stated interest rate. When the bond matures (the term of the bond expires), the company pays back the bondholder the bond's face value.

How does bonds work? ›

An investor who buys a government bond is lending the government money. If an investor buys a corporate bond, the investor is lending the corporation money. Like a loan, a bond pays interest periodically and repays the principal at a stated time, known as maturity.

What are the 3 characteristics of a bond? ›

All bonds have three characteristics that never change:
  • Face value: The principal portion of the loan, usually either $1,000 or $5,000. It's the amount you get back from the issuer on the day the bond matures. ...
  • Maturity: The day the bond comes due. ...
  • Coupon:
Nov 25, 1998

Which financial assets carries the most risk? ›

Equities are generally considered the riskiest class of assets. Dividends aside, they offer no guarantees, and investors' money is subject to the successes and failures of private businesses in a fiercely competitive marketplace. Equity investing involves buying stock in a private company or group of companies.

How do bonds lose value? ›

What causes bond prices to fall? Bond prices move in inverse fashion to interest rates, reflecting an important bond investing consideration known as interest rate risk. If bond yields decline, the value of bonds already on the market move higher. If bond yields rise, existing bonds lose value.

How do you make money from bonds? ›

You can make money on a bond from interest payments and by selling it for more than you paid. You can lose money on a bond if you sell it for less than you paid or the issuer defaults on their payments.

How do bonds make money for beginners? ›

Bonds are among a number of investments known as fixed-income securities. They are debt obligations, meaning that the investor loans a sum of money (the principal) to a company or a government for a set period of time, and in return receives a series of interest payments (the yield).

Should you buy bonds when interest rates are high? ›

Should I only buy bonds when interest rates are high? There are advantages to purchasing bonds after interest rates have risen. Along with generating a larger income stream, such bonds may be subject to less interest rate risk, as there may be a reduced chance of rates moving significantly higher from current levels.

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