Bonds are loans you can buy and sell, where an investor lends money to a government or company in exchange for regular interest payments

When you buy a bond, you are lending money. The borrower — usually a government, a city, or a corporation — promises to pay you interest on that money at set times, and to return the full amount on a specific date. That date is called the maturity date. The interest payment is called the coupon, even though modern bonds are not physical certificates with coupons attached anymore.

The reason bonds exist is straightforward: borrowers need money now, and investors want a predictable return. A bond is the contract that makes both sides comfortable. Unlike a stock, which makes you a partial owner of a company, a bond makes you a creditor — the company or government owes you money, and you have a legal claim to it.

Bonds are traded on markets, which means you can buy one from someone else who already owns it, or sell one you own to someone else. This is different from keeping a loan until it matures. That ability to trade is what makes bonds useful to investors who want to move money around or get out of an investment before the maturity date arrives.

Key Takeaways

  • A bond is a debt certificate where an investor lends money to a borrower in exchange for regular interest payments and the return of the principal amount at maturity.
  • The borrower can be a government (like the U.S. Treasury), a city or state, or a corporation, and each type of bond carries different levels of risk and return.
  • Bonds are traded on secondary markets, so you can buy a bond from another investor or sell one before it matures, which changes the price you pay or receive.
  • The interest rate on a bond is set when it is issued, but the market price of the bond changes based on interest rates, credit risk, and how much time remains until maturity.
  • Bonds are generally considered lower-risk investments than stocks because bondholders are paid before stockholders if a company fails.

How the bond issuer and investor make the deal

When a bond is first issued, the borrower sets the terms: how much money they are borrowing (the principal or face value), what interest rate they will pay (the coupon rate), how often they will pay it (usually twice a year), and when they will return the principal (the maturity date). The investor buys the bond at the issue price, which is usually the face value — for example, $1,000.

From that point forward, the investor receives interest payments on schedule. If a bond has a 4 percent coupon and a $1,000 face value, the investor receives $40 per year, usually split into two $20 payments. This continues until the maturity date, when the investor receives the final interest payment plus the full $1,000 principal back.

The borrower benefits because they know exactly how much they owe and when. The investor benefits because the payments are predictable and do not depend on the company's profits or stock price. If a company goes bankrupt, bondholders are paid from remaining assets before stockholders are.

Why bond prices change even though the interest rate does not

Once a bond is issued, its coupon rate is locked in. But the price of the bond on the secondary market — the market where investors buy and sell bonds from each other — moves up and down based on interest rates in the broader economy.

Here is why: if you own a bond paying 4 percent and new bonds are being issued at 5 percent, your bond is less attractive. To sell it, you have to lower the price so the buyer's total return matches what they could get elsewhere. If you own a bond paying 4 percent and new bonds are being issued at 3 percent, your bond is more attractive, and you can sell it for more than face value.

This matters because it means the price you pay for a bond on the secondary market is often different from its face value. You might pay $950 for a $1,000 bond, or $1,050. When the bond matures, you always get the full face value back, so the difference between what you paid and what you receive at maturity is part of your return.

The different types of bonds and who issues them

Treasury bonds are issued by the U.S. federal government. They are considered the safest bonds because they are backed by the government's ability to tax and print currency. Treasury bonds come in different lengths: Treasury bills mature in less than a year, Treasury notes mature in 2 to 10 years, and Treasury bonds mature in 20 to 30 years. The longer the maturity, the higher the interest rate, because investors want more return for locking up their money longer.

Municipal bonds are issued by states, cities, and local governments to pay for schools, roads, and other infrastructure. Many municipal bonds offer tax advantages — the interest you receive may not be taxed by the federal government, or by your state government if you live in the state that issued the bond. This makes them attractive to investors in high tax brackets, even if the interest rate is lower than other bonds.

Corporate bonds are issued by companies. They typically pay higher interest rates than government bonds because companies are riskier borrowers than governments. A company can go bankrupt; a government can usually avoid it by raising taxes or borrowing more. Corporate bonds are rated by credit rating agencies like Moody's and Standard & Poor's, which assess how likely the company is to pay back the bond. A higher rating means lower risk and lower interest rate.

What credit rating means and why it matters

A credit rating is a letter grade assigned to a bond by an independent agency. The highest ratings are AAA and AA, which mean very low risk. Ratings of A and BBB are still considered investment-grade, meaning the borrower is expected to pay. Ratings below BBB — BB, B, CCC, and lower — are called junk bonds or high-yield bonds, and they carry significant risk that the borrower will not pay.

The rating affects the interest rate the borrower has to offer. A company with an AAA rating might issue a bond at 3 percent. A company with a BB rating might have to offer 8 percent to attract investors, because investors demand higher return for higher risk. If a company's financial condition worsens, its rating can be downgraded, which causes the price of its existing bonds to fall on the secondary market.

Investors use ratings to decide which bonds fit their risk tolerance. A retiree living on investment income might buy only AAA-rated bonds. An investor with a longer time horizon and more risk tolerance might buy some junk bonds, betting that the company will survive and the higher interest payments will be worth the risk.

How maturity date and interest rates interact to shape your return

The longer a bond's maturity, the more sensitive its price is to changes in interest rates. A 30-year Treasury bond will drop more in price if interest rates rise than a 2-year Treasury note will, because investors have to wait much longer to get their principal back. This is called duration risk.

If you buy a bond and hold it until maturity, the price changes do not matter — you get your full principal back regardless. But if you need to sell before maturity, the current market price is what you receive. If interest rates have risen since you bought the bond, you will have to sell at a discount. If interest rates have fallen, you can sell at a premium.

This is why investors who might need their money back soon tend to buy shorter-maturity bonds, and investors with a longer time horizon can afford to buy longer-maturity bonds and wait out the price swings.

How bonds fit into a broader investment strategy

Bonds serve a different role than stocks in a portfolio. Stocks are ownership stakes that rise and fall with company performance and investor sentiment. Bonds are debt obligations that provide steady income regardless of how the company or government is doing. Because bonds and stocks often move in opposite directions — when stocks fall, investors buy bonds for safety, driving bond prices up — holding both can reduce overall portfolio risk.

An investor might hold a mix of Treasury bonds for safety, municipal bonds for tax advantages, and corporate bonds for higher yield. The exact mix depends on the investor's age, income, time horizon, and how much risk they can tolerate. A younger investor with decades until retirement might hold mostly stocks and a small amount of bonds. An older investor might hold mostly bonds and a smaller amount of stocks.

Bonds also provide a way to earn return without the volatility of stocks. If you need predictable income — for example, if you are retired and living on investment returns — bonds are more suitable than stocks because the payments are scheduled and the principal is returned on a known date.

Frequently Asked Questions

What is the difference between a bond and a stock?

A bond is a loan: you lend money and receive interest payments. A stock is ownership: you own a piece of the company and benefit if it grows. Bondholders are paid before stockholders if the company fails, making bonds lower-risk. Stocks have higher potential returns but more volatility.

Can I lose money on a bond?

If you hold a bond until maturity, you get your full principal back (assuming the borrower does not default). But if you sell before maturity and interest rates have risen, you will sell at a discount and receive less than you paid. You can also lose money if the borrower defaults and cannot pay.

Why would I buy a bond if the interest rate is so low?

Low interest rates reflect low risk. Treasury bonds pay low rates because they are backed by the government. If you need safety and predictable income more than high returns, a low-rate bond is appropriate. Investors also buy bonds to balance stocks in their portfolio, not just to maximize return.

How do I buy a bond?

You can buy bonds through a brokerage account, the same way you buy stocks. You can also buy Treasury bonds directly from the U.S. Treasury through TreasuryDirect.gov. Municipal and corporate bonds are usually bought through a broker. Bonds are also available through bond funds and ETFs, which hold many bonds and let you invest smaller amounts.

What happens if the company that issued my bond goes bankrupt?

Bondholders are creditors, so they are paid from the company's remaining assets before stockholders receive anything. You may recover some or all of your principal, depending on how much money is left. If the company has no assets, you may lose your entire investment, though this is rare for investment-grade bonds.