When you are developing your long-term investing strategy, we recommend having a mix of investments that includes bonds. Bonds are interest-paying investments that can help offset the risks and the price fluctuation of stocks.

What are bonds?

When you buy a bond as an investor, you essentially loan money to a government or corporate institution for a certain period of time at a fixed interest rate. Corporations, governments, states and municipalities use bonds to pay for activities that require big lumps of cash all at once, like infrastructure projects or expanding into new markets. Sometimes, bonds are referred to as fixed-income securities or fixed-income investments.

Because they pay regular income and can be relatively low-risk, bonds are a key part of a diversified investment portfolio. There are some short-term, unstable bonds to know about, but we’ll discuss those a bit later.

Before we discuss how, why and where to buy bonds, below are a few basic words that are useful to know.

Bond issuer

The government or corporation that borrows money from investors by creating the bond is the issuer. They are indebted to the investors (or whoever those first investors sell their bonds to) because the investors have loaned the issuer money by investing in their bonds. In return, the issuer pays interest on that loan to the owners of the bonds.

Bond creditor

As the purchaser of a bond, you are a creditor of the government or corporation that issues the bond. They owe you interest on that money, and promise to pay the loan back when the bond matures. As a creditor, you’ll demand higher interest rates if you think there’s a risk that the issuer might not be able to pay you back.

Coupon rate

A bond coupon rate is the interest that the issuer will pay bond owners each year, usually in annual or semi-annual payments, until the bond matures. Some bonds, called “zero coupon bonds,” pay no interest until you get a big lump sum at the maturity date.

Bond principal or face value

The bond principal, also sometimes called the bond’s face value, is the amount the bond owner receives at the maturity date and usually is the price the first owner of the bond pays. It’s the basis for any interest paid. A bond with a face value of $1,000 and a 5% coupon pays $50 per year in interest.

Maturity date

The maturity date is the date when the principal must be returned to you — paid back — in full. This also is the date when you stop receiving interest on your bonds.

How do bonds work?

There are many types of bonds, but the two most important characteristics are the term of the bond — how long it is until you get the principal back — and the creditworthiness of the issuer. When you invest in bonds or, more likely, bond mutual funds, it’s essential to understand which type you’re buying because that tells you how risky the bonds are. Some bonds are stable and low-risk, but that isn’t universal.

What are bond terms?

Term is usually broken down into three main categories: short-term, intermediate-term and long-term. The exact definition varies, but short-term bonds typically mature in five years or less, intermediate-term bonds in 10 years or less and long-term anything beyond that.

Short-term bonds mature very soon, so aren’t much riskier than Certificate of Deposit (CD) accounts or money market funds as long as the issuer is sound. Longer-term bonds are riskier, because they lock you into a fixed interest rate for longer — it might turn out to be a low rate, and it’s just more time for the issuer to run into problems. Intermediates fall in between. You’ll usually earn a slightly higher yield (interest rate) on bonds and bond mutual funds that have longer terms, though that is not always the case.

Who issues a bond?

Because a bond is a loan, you as an investor need to know how creditworthy the issuer is.

Here are the main categories of issuers — as with terms, you’ll often see these mentioned in the name of a mutual fund that invests in that specific issuer type.

U.S. Government bonds (treasury bonds, notes and bills)

The U.S. government issues debt regularly to finance its spending, primarily in the form of U.S. Treasury bills, notes and bonds. The term determines the name if the debt. Treasury debt is considered extremely safe and is one of the most widely owned and traded investments in the world. The U.S. government backs the interest and principal and the interest rate is fixed at the time of purchase. Because they’re low risk, these all typically pay relatively low interest rates.

A second and less-common type of bond from the U.S. Treasury is called Treasury Inflation-Protected Securities (TIPS). These are issued and backed by the U.S. Treasury, but their interest rate isn’t fixed. Instead the bond pays a base rate, plus a bonus based on the inflation rate.

The third type of bond from the U.S. Treasury is the U.S. Savings Bond. Unlike the other types, savings bonds aren’t traded among investors. Instead they’re bought and held by the original owner until that person or their heir decides to cash them in — which can be decades later, when the bond stops accruing interest or much sooner. At that time, interest is paid out and taxes are due on that interest. There can be tax breaks on that interest if you also pay education expenses that year.

There are currently two types of savings bonds being issued: Series EE bonds, which have an interest rate that changes periodically based on Treasury Bond rates, and Series I bonds, which are similar to TIPS because the interest rate varies based on the rate of inflation.

Treasury bills, notes and bonds, as well as TIPS, can be purchased directly from the U.S. government at original issue or in the secondary market through any brokerage account. For this reason, you can find Treasury debt that matures anywhere from a week or two from now to more than 20 years from now — and just about any month in between. But in practice, most investors don’t own any Treasury notes or bonds individually — they own them through mutual funds.

In contrast, savings bonds are owned only by individuals and never through mutual funds. You can purchase U.S. savings bonds through many commercial banks and through the federal government's Treasury Direct website.

• Treasury Direct: www.treasurydirect.gov/indiv/products/products.htm

Agency bonds

Agency bonds are issued by federal government agencies and privately owned, federally chartered corporations called Government Sponsored Enterprises (GSEs). The Federal Housing Agency, the Federal Home Loan Mortgage Coalition (Freddie Mac) and the Federal National Mortgage Association (Fannie Mae) are the most common examples of GSEs. These are all mortgage bonds.

When you own bonds from these GSEs, you receive a share of mortgage payments from a group of homeowners. A special category of these bonds, called GNMA (Ginnie Maes), is backed by the full faith and credit of the U.S. government so is popular with retirees seeking income. Most investors own agency bonds only through mutual funds because they are more complicated investments than U.S. Treasury bonds.

These federal agencies issue bonds to help pay for public projects, such as homeownership programs. Agency bonds come in a variety of structures, coupon/interest rates, and maturity dates.

• Federal Industry Regulatory Authority (FINRA):
  apps.finra.org/investor_information/smart/bonds/303000.asp

Corporate bonds

Corporations regularly borrow money by issuing bonds to investors. The corporate bond market is larger than U.S. Treasury, savings and agency bond markets. Corporate bonds tend to yield more than U.S. government bonds but, because corporations aren’t nearly as secure as the government, they are higher risk. Most investors own corporate bonds only through mutual funds, because they are difficult (or for many, impossible) to trade in small dollar amounts.

• Securities Industry and Financial Markets Association (SIFMA):
  www.investinginbonds.com/learnmore.asp?catid=10&subcatid=47

Foreign and global bonds

The last issuer category you may come across when researching bonds and bond mutual funds is foreign or global bonds. These are bonds that are issued in countries other than the United States, by governments or corporations, and often they are denominated in foreign currencies (instead of buying a $1,000 bond, you buy a €1,000 Euro bond that pays its interest in Euros). A global bond mutual fund usually includes US bonds as well as foreign ones.

Foreign bonds have additional risks because of both the foreign issuer and the fact that they aren’t denominated in dollars. You’re concerned with not just the interest paid on the foreign bond, but also the exchange rate for switching that bond’s interest payments and return of principal at maturity back into dollars that you can spend. Given these complexities foreign bonds are owned almost exclusively through mutual funds.

Junk and high-yield bonds

No description of bonds would be complete without mentioning junk bonds — or, as Wall Street likes to call them, high-yield bonds. Junk bonds are bonds whose issuers are believed to be risky — meaning they might not be able to make good on their promised payments to bond owners. Usually these are from corporations, but at times government bonds from some foreign countries, and some municipal bonds, will be considered junk because of specific problems in the region that issued the bond.

You’ll see high-yield bond mutual funds in many categories, and you’ll need to read the fund prospectus to understand exactly what a given fund invests in. The higher yield of junk bonds may be tempting, but keep in mind that these bonds also have a much greater risk of losing money at some point.

Municipal bonds

Municipal bonds, usually referred to as munis, are issued by state and local governments and some local projects — such as those for housing, roads or stadiums. They’re usually owned by wealthier investors because their key feature is that their interest is exempt from federal as well as state and local taxes. For that reason, they usually pay lower interest rates than other bonds. The rate only makes sense if you pay a lot in income taxes on regular interest.

You can purchase mutual funds that invest in municipal bonds, but many investors instead buy them at original issue and hold them until maturity — which can mean 15-20 years or more. Municipal bonds also can be traded after original issue in a brokerage account, but many of these bonds trade very infrequently so the pricing when you buy or sell can be poor.

Why should I buy bonds?

Bonds are the main income-paying investment available to investors. That in itself is a big benefit. Once or twice per year, or even monthly if you own bond mutual funds, you get new cash in your account to spend or invest.

Even if you don’t need that income, bonds have benefits. Because they pay a known amount of income and return your principal on a known date, most bonds are more stable in value than stocks. Bond prices don’t follow stock prices — when stocks prices fall, bond prices often rise. And mutual funds that own bonds have these traits too. Owning at least some bonds makes an investment account go up and down in value less, as compared to one that only owns stocks.

When you are developing your long-term investing strategy, we recommend having a mix of investments that includes bonds. Bonds are an important part of your balanced portfolio because they help offset the risks and the price fluctuation of stocks.

The rationale for owning savings bonds is a bit different. While the savings bonds your older relatives bought years ago paid very good interest rates, today’s savings bonds pay much less. Still, they can be a good substitute for a CD, savings account, or money market fund for a part of your emergency fund that you don’t plan to tap into anytime soon. And if you’ll qualify for their education-related tax breaks, savings bonds are a good source of funds for that when the time comes.

How do I pick bonds?

As with any investing strategy, we recommend focusing on diversifying what you invest in. That’s the reason most people only own bonds through bond mutual funds. To diversify yourself by owning individual bonds — including a bunch of different issuers and terms — you’d need a lot of money to invest, given that bonds are typically issued only in big denominations like $1,000, $5,000 or $10,000.

If you stick with mutual funds, picking bonds can be relatively simple. Choose a mutual fund that invests in bonds with the term and issuer that matches up to your needs. Or, buy one of the total bond market kinds of funds that owns a very wide mix of them.

As with any mutual fund, keeping costs low is important, so be sure to understand the total fees and expenses of any bond mutual fund you’re thinking of investing in. The cost issue is doubly true for bonds, which might be earning only 4-5% or less each year before those expenses.

If buying U.S. Savings bonds, the choice is simply between an EE or I bond, so you don’t have to go through a mutual fund. Read up on current rates, understand how soon you can cash each in, and decide whether you prefer the inflation protection you get with the I bond or the fixed rate you get with the EE bond.

• See also: Mutual fund

Words to know


Unsure about something you read?

Many of the financial terms you came across in this article are defined in our financial glossary. A-Z Glossary

Links we like


Here are a couple online features you might find useful:

• Treasury Direct:
  www.treasurydirect.gov/indiv/products/products.htm
• Federal Industry Regulatory Authority (FINRA) bond basics:
  apps.finra.org/investor_information/smart/bonds/101000.asp
• Securities Industry and Financial Markets Association (SIFMA) investing in bonds: www.investinginbonds.com/learnmore.asp?catid=10&subcatid=47