Bond

What is a bond?

A bond is a loan you give to a government or a company. They borrow your money, pay you interest along the way, and pay you back on a set end date, called the maturity date. High-quality bonds are among the steadier ways to invest.

Key takeaways

• You lend money to a government or company, and they pay you back with interest.
• U.S. government bonds are considered the safest. Corporate bonds usually pay more because they carry more risk.
• Most bonds pay interest on a regular schedule (often twice a year), then return your money at maturity.
• If you hold to maturity and the issuer doesn't default, you get your money back. Sell early, and the price could be higher or lower than what you paid.
• Bonds are for stability and income, not for getting rich quick. Many people mix them with stocks for balance.

How it works

Say your roommate asks to borrow $100. You agree, as long as they pay you back in a year plus $5 extra for the favor. They pay the $5 in pieces during the year, then hand back your $100 at the end. That's a bond.

With a real bond, the borrower is the U.S. government, a company, or your city, and the amount is often $1,000 or more.

Why do governments and companies borrow?

Governments need money for things like roads, schools, and defense. Companies need money to open stores, build products, or expand. Instead of borrowing only from banks, they borrow from investors like you. Lots of people each lend a little, and the borrower gets the large sum it needs.

How you make money

1. Interest payments. The bond pays a set percentage every year. In a hypothetical example, you lend $1,000 at 5% interest, so you get $50 a year. Most bonds pay twice a year, so that's $25 every six months.

2. Your money back at maturity. Say the bond lasts 10 years. After 10 years of $50 payments ($500 total), you also get your original $1,000 back. You earned $500 for lending your money.

Can you lose money?

If you hold the bond until maturity and the issuer pays as promised, you get your full amount back. The main risks:

• Default: The issuer can't pay. This is very unlikely with the U.S. government and more likely with weaker companies.
• Selling early: Bond prices move while you hold them. If interest rates rise after you buy, your bond's price falls, and selling before maturity could mean a loss.
• Inflation: Fixed payments buy less as prices rise. (See real rate of return.)

Are bonds boring? Yes, and that's the point. Stocks are the rollercoaster. Bonds are the steady ride.

The three main types

1. U.S. government bonds (Treasuries)

Backed by the full faith and credit of the U.S. government, these are considered the safest bonds. Because they're so safe, they usually pay less interest than corporate bonds.

• Treasury bills (T-bills): Mature in one year or less.
• Treasury notes: Mature in 2 to 10 years.
• Treasury bonds: Mature in 20 or 30 years.

Good for people who want as little risk as possible.

2. Corporate bonds

Issued by companies. They pay more because there's a chance the company can't pay you back.

• Investment-grade bonds: From financially strong companies. Lower risk, with more interest than Treasuries.
• High-yield ("junk") bonds: From shakier companies. Much higher interest and much higher risk.

If you want more interest than Treasuries but still want stability, stick with investment grade.

3. Municipal bonds ("munis")

Issued by cities, states, and local governments to fund things like schools and roads. The interest is usually exempt from federal income tax, and bonds from your own state may be exempt from state tax too. Because of that tax break, munis usually pay less interest, so they tend to make the most sense for people in higher tax brackets.

When bonds make sense

• You're nervous about the stock market. Bonds usually don't swing as hard when stocks crash.
• You'll need the money sooner. If you're 55 and plan to retire at 65, you have less time to wait out a stock crash.
• You want regular income. Bonds pay interest on a schedule. Stock dividends aren't guaranteed.
• You want balance. When stocks fall, high-quality bonds often hold steadier, which cushions your portfolio. This is called diversification.

A common rule of thumb is to hold roughly your age as a percentage in bonds. At 25, that's about 25% bonds and 75% stocks. At 60, about 60% bonds. It's a starting point, not a hard rule.

When you may not need many bonds

If you're in your 20s or early 30s and won't need the money for decades, you have time to ride out stock market swings. Over long periods, stocks have historically grown more than bonds, so younger investors often lean heavier on stocks. (See equities.)

How to buy bonds

1. Directly from the U.S. government at TreasuryDirect.gov, the official site for buying Treasury bills, notes, and bonds.
2. Through a brokerage, where you can buy Treasuries, corporate bonds, and munis like you'd buy stocks.
3. Through a bond fund or bond ETF, which holds many bonds for you. It's like buying a smoothie instead of individual fruit. Broad bond index funds, such as those tracking the total U.S. bond market, are often the easiest option for beginners. (See index.)

Bonds by life stage

• Just starting out in your 20s? Stocks and index funds usually do most of the work. Bonds can wait.
• Building wealth in your 30s or 40s? Adding some bonds can smooth out the ride.
• Close to retirement or needing the money soon? Bonds often become a bigger part of the plan, since stability and income matter more than maximum growth.

FAQs

What happens if interest rates go up after I buy a bond?

Your bond's market price goes down, because new bonds pay more. If you hold to maturity, you still get your full amount back plus all the interest. The price change only matters if you sell early.

Can I sell a bond before it matures?

Yes, but the price may be higher or lower than what you paid, depending on interest rates at the time.

Are bonds better than a high-yield savings account?

It depends. Savings accounts let you withdraw anytime and are FDIC insured up to the limits. Bonds may pay more but tie up your money or expose you to price changes if you sell early. Both can have a place in your plan.

Do I pay taxes on bond interest?

Usually. Treasury interest is taxed federally but not by states. Corporate bond interest is taxed at both levels. Municipal bond interest is usually exempt from federal tax.

What's the minimum to buy a bond?

Treasuries on TreasuryDirect can be bought in small amounts. Individual corporate bonds often have higher minimums. Bond funds and ETFs usually let you start with the price of one share, or less with fractional shares.

Should I buy individual bonds or bond funds?

For beginners, bond funds are simpler and give you instant diversification. Individual bonds make more sense if you want to control exactly when you get paid back.

Related terms

• Compound interest
• Index
• Equities
• Real rate of return