Bonds

Background

Bonds are fixed-income investments that allow individuals to lend a specific amount of money to a large entity, like a government or corporation, for a set amount of time in return for interest that pays out over the life of the loan. Their main function is to help these large entities finance projects and business ventures.

While they’re seen as predictable investments, the returns are less lucrative compared to other investment options, like stocks (more here). 

Types of Bonds

There are three main types of institutions that issue new bonds: government, corporate, and municipal. They each sell their own types of bonds, which have their own functions, rules, and rates. 

Government bonds, often called Treasurys, help finance new infrastructure like highways. The US Government offers different types of bonds called bills, notes, bonds, and Treasury Inflation-Protected Securities, which all have different interest rates and loan lengths (compare the most popular savings bonds here). Investors can buy a bond for as little as $25.

Corporate bonds help finance the operating costs or business ventures of corporations. However, unlike stocks, investors don’t own a portion of the company when buying a bond from a corporation. They offer higher returns than other bonds, but also carry higher risk since they’re more likely to default on a loan than the government (learn about more risks here). The average cost of a corporate bond can range from $1K to $5K. 

Municipal bonds help cover a government body’s expenses. Like  government bonds, they fund projects like building schools or bridges. Interest earned on “munis,” as they’re often called, are typically exempt from federal taxes.

How Bonds Work

There are three main elements of a bond: the principal amount, the interest rate, and the maturity date. 

The principal amount refers to the amount the investor will initially pay for the bond—that’s the base cost the bond issuer must pay the investor back.

The interest rate (or the coupon rate) determines how much money the bond issuer will owe the investor on top of the principal amount throughout the life of the loan. 

The maturity date is when the bond expires, and the principal amount must be paid back in full to the investor.

The bond issuer sets the terms of the bond, which include the interest rate, the interest payment dates (called “coupon dates”), and the maturity date. These factors determine the final price of the bond. 

Investors can sell their bonds on the secondary market (where investors can trade investments). If they do sell, they won’t be able to collect all of the interest before the maturity date, though they may be able to collect some. If bondholders hold out until the maturity date, they’ll collect the principal value (called the face value) and all interest payments. 

Inflation

Most bonds operate at a fixed interest rate for the life of the loan, so inflation can lower the value of an investor’s return over time, ultimately impacting the bond’s market value. When prices are on the rise, bond investors tend to want higher interest rates for bonds (learn more here).

However, not all bonds are subject to the negative impacts of inflation: TIPS rates and I-Bond rates keep up with the rate of inflation.