What Is a Bond?

Bonds are known as fixed income securities, also known as a debt security. These are loans or IOUs between the lender (the investor) and the issuer (typically a company or government) that provide a fixed interest payment to the lender.

Bonds, explained

Governments often use bonds to cover expenses such as infrastructure improvements (roads, government utilities, etc.) and wartime purchases. Governments may also use funds for purposes such as building new schools or funding various social projects.

Companies borrow bonds for several reasons, but the primary benefit is that it’s a way to quickly raise capital without selling stock or borrowing from a bank. Companies can use this capital to fund new projects, hire employees, build a factory, etc.  

All bonds come with details of the loan and repayment, such as when the bond owner will receive their principal back, as well as what the interest rates are. Bonds are considered low-risk investments because of these terms. Usually, a bondholder will receive interest payments a set number of times per year until the contract is up, at which point they will receive their full principal back.

Main types of bonds

A bond’s type is determined by the issuing entity. There are four main types of bonds available on the market, each with various subtypes that carry different terms.

• Corporate bonds are issued by companies. These are some of the riskiest bonds available but can offer greater rewards.
• Investment-grade bonds have a higher credit rating than high-yield bonds but may offer lower interest.
• High-yield bonds have a lower credit rating than investment-grade bonds but offer higher interest as compensation.
• Municipal bonds are issued by states and cities. These bonds are usually a safe bet but do carry some risks.
• Government bonds are issued by sovereign governments; collectively called “treasuries.” Typically, these are the safest kind of bond for investors to buy. Many Treasuries are zero-coupon, which means they pay no interest until maturity.
• Bills mature in one year or less
• Notes mature in 1 to 10 years
• Bonds mature in 10 years or more
• TIPS (Treasury Inflation-Protected Securities) adjust their principal according to the Consumer Price Index to eliminate the risk of inflation. These pay semiannual coupons and come with 5, 10, and 30-year maturities.
• Agency bonds are issued by government-affiliated companies such as Freddie Mac. These bonds typically have lower interest rates than some corporate bonds but higher rates than government bonds. 

Note that it’s also possible to purchase bonds issued by foreign governments on some markets. However, due to the differences in terms and regulations, we won’t cover these here.

What this means for you

There are several reasons that an investor may purchase bonds, but the underlying principles come down to steady returns and lower volatility than other securities.

For instance, investors who use their portfolio to provide income now instead of in the future may invest in a large number of non-Treasury bonds to increase their income in the short-term. Most bonds pay interest semiannually – while the amount isn’t enormous, owning a large number of bonds can lead to hefty returns.

Furthermore, an investor may use bonds to diversify and reduce the overall risk of their portfolio. Properly utilized, bonds provide a safe way to balance risks in the stock market with steady returns and repayment of bond coupons and maturities.

Investors also use bonds as a way to “hold” their capital in a semi-safe place. An investor who keeps a bond until maturity will receive coupon payments and the principal of the bond upon maturity. This is a way to put your capital to work and receive it back at the end.