Bonds are an asset class much like stocks, commodities and real estate. But unlike these three, bonds represent loans made by investors to borrowers. These borrowers are known as bond issuers and are often either government or corporate entities.
Aside from paying back the principal, the bond issuer also pays interest — which can be fixed or variable. This is known as the coupon. Because the bondholder earns interest, bonds are also known as fixed-income securities.
Bonds are designed to provide the bond issuer with funds for investments or expenditure. Depending on who issues the bond, there are three major types: corporate, government and municipal.
Companies may resort to traditional loans or bonds to get funds for investments or to cover day-to-day operations. Because bonds often come with lower interest rates and more favorable terms than traditional loans — companies may prefer to choose the bonds route.
But since companies may go bankrupt or fail to pay off their debt, corporate bonds can have a higher risk than US government bonds.
Tax implications: Corporate bonds are subject to both federal and state income tax.
As the name suggests, government bonds are issued by the government. In the US, that’s the Treasury Department.
Because of that, they are often referred to as “Treasuries” or sovereign debt. And since this type of bond is backed by the US government, they are considered one of the safest investments.
Depending on the length of the bond’s maturity, government bonds have different names. For example:
Tax implications: Government bonds are subject to federal taxes but are often exempt from state and local taxes.
Municipal bonds, also known as “munis,” are issued by states, cities and counties, as well as government agencies. These are often used to fund local projects, such as schools, sewers and highways.
Tax implications: Interest income from municipal bonds is usually exempt from federal tax and may be exempt from state tax as well. However, capital gains are often taxed.
When a company or government entity needs money either for investments or day-to-day obligations, it can issue bonds. The bond issuer sets the terms, i.e. the bond’s face value, maturity date and interest rate.
The maturity date is the day when the bond issuer has to pay the principal back to the bondholder. The interest rate is the amount, say 5% annually, paid to the bondholder.
The face value is what the bond issuer will pay for each bond on the maturity date. It’s also the value on which the interest rate is calculated.
Here’s how that would work:
For comparison, the same $9,000 investment in the S&P 500 index with an average annual return of 10% would earn $10,192 or 114% return on investment.
Creditworthiness and date of maturity are often the two factors that determine the interest rate. If the bond issuer has a poor credit rating and the risk of default is high, the interest rate will be high as well. The opposite also applies — low-risk bonds, such as treasuries, pay low-interest rates.
The bond’s issuer credit quality also affects the market price on the secondary market, meaning quality bonds may cost more than the bond’s face value.
| Term | Definition |
|---|---|
| Call feature | A feature that allows the bond issuer to buy back bonds at a set price in the future. Not all bonds are callable. |
| Coupon | A coupon is the annual interest rate paid on the bond’s face value. |
| Coupon date | This is the date when the bond issuer pays the interest rate to the bondholder, typically twice each year. |
| Credit quality | A measure of a company or government entity to pay its debt. |
| Default | A bond default is when the bond issuer fails to pay the interest or the principal back to the bondholder within the specified period. |
| Discount | A discount is when the bond’s price on the market is lower than its face value. |
| Face value | This is the bond’s value paid on the maturity date. |
| Investment grade | Bonds with high ratings and low risk of default are called investment-grade bonds. |
| Issuer | The company or government entity that issues the bonds. |
| Junk | A term used for high-risk bonds. |
| Maturity date | The date when the bond issuer has to repay the principal back to the bondholder. |
| Par | Par is the same as face value. |
| Premium | This is when the bond is priced higher than its face value on the secondary markets. |
| Price | The present market value of a bond, which may differ from the face value. |
| Principal | The amount of money the bond issuer has to pay to the bondholder on the maturity date. |
| Yield | This is the return an investor would earn on a bond investment. |
Bonds are assessed by bond rating agencies that take into account the issuer’s financial strength and its ability to pay back the principal and interest on time.
The most popular rating agencies are Moody’s, Standard and Poor’s, Fitch Ratings and DBRS. Each of these agencies has its own grades, but in general, bonds with an AAA rating are considered investment grade with low risk. On the other hand, bonds rated CCC are considered junk with a higher risk of default.
Finding bond ratings is simple no matter which agency you go with. For example, if you choose Fitch here’s how to find the ratings:
Bonds may not be the first choice for growth investors because they often come with lower returns. But other investors may find the bond’s advantages appealing.
Despite its advantages, there are some risks to consider.
There are three ways to buy bonds: via a Brokerage platform, as an exchange-traded fund (ETF) or directly from the Treasury Department.
Accessing the bond market via an online brokerage is one of the simplest and fastest ways to buy bonds. Here’s how:
ETFs are a simpler way to buy bonds. That’s because not every broker lets you buy bonds, but almost every broker allows you to buy ETFs. To buy ETF bonds, you need to:
Buy government bonds with a minimum of $100 directly from the Treasury Department. This is a slightly more complex way to buy bonds than using the previous methods. Here’s how it works:
| Response | % of investors |
|---|---|
| Stocks | 51% |
| Real estate | 35% |
| Other | 4% |
| High interest savings account | 48% |
| Forex (e.g. USD or Euro) | 5% |
| Fixed deposit | 15% |
| Cryptocurrency | 24% |
| Commodities (e.g. gold or oil) | 21% |
| Bonds | 24% |
About a quarter (24%) of investors say now is a good time to invest in bonds, making it the 4th most popular option behind stocks, high interest savings accounts and real estate.
As an asset class, bonds are worth considering for investors looking for low-risk, fixed-income options. But this only works for investment-grade bonds. Junk bonds may be good for those who want to make higher returns, but the risk of default is also high.
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