There are four types of bonds you should know, each with their own risk profiles, coupons, tax implications and risks and rewards. By researching each of these bond types, you’ll learn which type is right for your portfolio and investment aims. Inflation can significantly diminish the buying power of a bond’s fixed interest payments, making them less valuable.
Treasury bonds
In exchange for higher risk, high-yield bonds offer attractive coupons to investors. While you can earn more in yield from junk bonds, you should consider how much risk your portfolio can tolerate and whether you can lose all of your principal investment. Interest income earned from tax-exempt municipal securities generally is exempt from federal income tax and may also be exempt from state and local income taxes if you are a resident in the state of issuance. A portion of the income you receive may be subject to federal and state income taxes, including the federal alternative minimum tax. You may also be subject to tax on amounts recognized in connection with the sale of municipal bonds, including capital gains and “market discount” taxed at ordinary income rates.
Longer maturities usually mean the bond price has a higher likelihood of dropping more as interest rates rise, which indicates higher interest rate risk. Investors can calculate a bond’s duration, which is a measure of interest rate risk based on factors such as a bond’s maturity and yield. Unlike many other types of bonds, these savings bonds can’t be traded, and you don’t receive interest payouts along the way. Instead, interest accumulates while you hold the savings bond, and you can cash out later to receive repayment of your initial loan plus interest. That said, some bonds in personal finance are debt instruments that can not be traded.
For example, debt could mean credit card debt, where you have a balance with a credit card issuer that fluctuates as you pay off and spend on the card. But a bond is a security, meaning that it can typically be traded and has set terms, such as how the interest is calculated and when the bond matures. Bonds can provide regular income through interest payments on a fixed schedule. In contrast, stocks might not provide much or any income (depending on if they pay dividends), unless investors sell their stocks.
Interest payments
Once the bond reaches maturity, the bond issuer returns the investor’s money. Fixed income is a term often used to describe bonds, since your investment earns fixed payments over the life of the bond. Bond credit ratings help you understand the default risk involved with your bond investments. They also suggest the likelihood that the issuer will be able to reliably pay business stories book investors the bond’s coupon rate. Banks and other lending institutions pool mortgages and “securitize” them so investors can buy bonds that are backed by income from people repaying their mortgages.
What is a bond in simple terms?
Bonds are fixed-income securities and are one of the main asset classes for individual investors, along with equities and cash equivalents. The borrower issues a bond that includes the terms of the loan, interest payments that will be made, and the maturity date by which the bond principal must be repaid. The interest payment is part of the return that bondholders earn for loaning their funds to the issuer. The interest rate that determines the payment is called the coupon rate. Municipal bonds ( called “munis”) are debt securities issued by states, cities, or counties to fund public projects or operations. Like other type of bonds, they can also provide steady interest cash flow for the investors.
- While price changes affect returns if you need to sell early, if you hold until maturity, you would still get the full principal repaid by the issuer.
- Because they’re so safe, yields are generally the lowest available, and payments may not keep pace with inflation.
- While a bond’s price also fluctuates from day to day like a stock’s value, bonds generally exhibit less volatility than stocks.
- Credit ratings for a company and its bonds are generated by credit rating agencies like Standard and Poor’s, Moody’s, and Fitch Ratings.
- The bond investor is the individual or institution that purchases the bond, thereby lending cash to the issuer.
How do I know if a bond is a good investment?
A bond also has a finite life and a promise to repay the owner its principal value at maturity, whereas stocks are perpetual. The availability of bonds varies by broker, but you may be able to buy individual bonds — either newly issued ones or existing bonds that are trading on the secondary market — through your brokerage account. You also may be able to buy bond funds through your brokerage account. The three main bond-rating agencies are Moody’s, Standard & Poor’s (S&P), and Fitch.
- In exchange for higher risk, high-yield bonds offer attractive coupons to investors.
- Higher-rated bonds are considered safer and can be attractive even with lower yields, whereas lower-rated bonds typically offer higher yields to compensate investors for taking on more perceived risk.
- These four bond types also feature differing tax treatments, which is a key consideration for bond investors.
S&P, Fitch, and Moody’s non-investment-grade ratings
But credit ratings and market interest rates play big roles in pricing, too. Generally, bonds with longer maturities have higher interest rates, as issuers compensate investors for the longer commitment of their money. Sometimes a long maturity is risky, as there’s more time for interest rates to change, which can influence bond prices. While U.S. Treasury or government agency securities provide substantial protection against credit risk, they do not protect investors against price changes due to changing interest rates.
Though they have a par value, they can be traded at a discounted or premium price. Further, bondholders have a stake in a business as they are entitled to the interest and repayment of principal on maturity. However, unlike equity holders, they are not owners and have no claim in the company’s profits. They are commonly known as treasuries, because they are issued by the U.S. Money raised from the sale of treasuries funds every aspect of government activity. They are subject to federal tax but exempt from state and local taxes.
Different bond types—government, corporate, or municipal—have unique characteristics influencing their risk and return profile. Understanding how they differ and the relationship between the prices of bond securities and market interest rates is crucial before investing. This can help confirm that your bond choices align with your financial goals and risk tolerance. Another top-rated bond index fund is the Fidelity U.S. Bond Index that primarily includes the intermediate-term debt securities. These debt securities offer an SEC yield of 1.1% while its expense ratio is just 0.025%. The best part of this fund is its diversified portfolio with around 2300 different bonds (37% of which are U.S. treasuries), which provide fixed income opportunities to the holders.
Once you’ve determined your preferred bond type and budget, consider the yields, maturity dates and risk of the available bonds. If you’re considering a bond fund, check the fees and portfolio of your fund options. While they’re often considered a safer investment than equities, bonds are not risk free and do carry some downsides, especially junk bonds.
However, they may carry a call risk, meaning the issuer can repay the bond before its maturity date. A bond is simply a medium of loan for the companies and the government. The funds so accumulated by the issuer can be used to pay off debts, initiate new projects, or meet other financial requirements. However, lenders are individuals or institutions looking forward to making long-term investments to earn stable returns.
Generally speaking, the higher a bond’s rating, the lower the coupon needs to be because of lower risk of default by the issuer. The lower a bond’s ratings, the more interest an issuer has to pay investors in order to entice them to make an investment and offset higher risk. Government Sponsored Enterprise (GSEs) like Fannie Mae and Freddie Mac issue agency bonds to provide funding for the federal mortgage, education and agricultural lending programs. These bonds are subject to federal tax, but some are exempt from state and local taxes. The IOUs of the financial world, bonds represent a government’s, agency’s, or company’s promise to repay what it borrows—plus interest. Though they typically don’t make the attention-grabbing moves that stocks do, bonds can be a vital component of your financial plan, offering potential stability and a steady income stream.
YTM evaluates the attractiveness of one bond relative to other bonds of different coupons and maturity in the market. The initial price of most bonds is typically set at what is called their par value, or the face value of one bond. The actual market price of a bond depends on the credit quality of the issuer, the length of time until expiration, and the coupon rate compared to the general interest rate environment. The face value of the bond is what is paid to the lender once the bond matures.
Analyze your bond portfolio
Investors usually pay par when they buy a bond from the issuer, unless it’s a zero-coupon bond, which we cover more below. If investors buy the bond from someone else (meaning they buy it on a secondary market), they may pay more or less than face value. Check out our guide on bond prices, rates, and yields for more on how bond rates change over time.