What Are Bonds? | An Introduction to Bonds

Broadly speaking, fixed income refers to any type of investment that generates regular interest payments, as opposed to variable returns that can fluctuate like stocks. One of the most common forms of fixed income is a bond. In simple terms, a bond is essentially an IOU that represents the amount of capital one borrows from an investor. While bonds may seem complex, understanding the core concepts can help both novice and experienced investors decide if and how these investments fit within their personal financial goals and risk tolerance. 

What Are Bonds?

When a bond is issued, the issuer – typically a government entity or corporation – is essentially borrowing capital from the bondholder. In exchange, the issuer agrees to pay the bondholder periodic interest payments as well as repay the total principal amount when the bond matures or reaches its stated maturity date. The bond denotes the amount borrowed (principal), the interest rate, and when interest and principal will be paid back. 

Interest rates play a key role. Because the coupon rate is set when the bond is first issued, it remains fixed over the life of the bond regardless of market rates. This provides bondholders security in knowing the regular interest income they will receive. However, the tradeoff is that they are more sensitive than other investments to changes in interest rates, as we’ll explore later.

What Are The Types of Bonds?

Under the broad umbrella of fixed income, there are different categories of bonds:

• Treasury bonds are backed by the US government and are considered very low risk. The main types are T-bills (maturing in 1 year or less), T-notes (2-10 years), and T-bonds (10-30 years).
• Municipal bonds are issued by state and local governments, with interest that is often state tax-exempt, making them appealing to residents of high-tax areas. 
• Corporate bonds are sold by companies and are viewed as more risky than government bonds. They also pay higher yields to compensate for this added risk.
• Agency bonds are issued by government-sponsored enterprises like Fannie Mae and Freddie Mac. They are considered safer than corporate bonds.

It’s important to understand the unique risks and potential benefits associated with various bond types to select those appropriate for individual circumstances. Bondholders are essentially loaning capital to the issuer, so credit quality and risk of default should be carefully evaluated.

Additional Factors

There are a few other terms investors should grasp:

– Coupon: The interest rate is paid out periodically, usually twice a year. A 5% coupon bond will pay 5% of the face value annually.

– Maturity: The date when the bond’s principal is paid back in full. Short-term bonds mature in under 5 years, intermediate in 5-10 years, and long-term over 10 years. 

– Yield: The total returns an investor receives, including both the coupon payments and price changes if it is later sold. Yield rises when prices fall. 

– Duration: A measure of interest rate sensitivity – the longer the duration, the greater the price moves in response to rate changes. Shorter bonds have less duration risk. 

– Call feature: Some corporate and municipal bonds can be paid off early if rates drop. Issuers “call” these bonds to refinance at lower rates.

The Importance of Diversification

As with any investment class, proper diversification is important when adding bonds to a portfolio. Mixing short, intermediate, and maybe longer-term bond maturities from a variety of 1-10 year durations; various issuers like treasury bonds backed by the full faith of the US government, high-quality investment grade corporate bonds from stable companies, and internationally from other developed countries; and laddering maturities so they mature consistently throughout the year can help offset bond-specific risks related to interest rate movements and credit quality while smoothing total returns over time.

Overall portfolio risk is also reduced through bonds’ tendency to fluctuate differently than stocks, providing returns that often have a low correlation during periods of stock market volatility. For reliable interest income and a potential hedge against stock market downturns, bond allocation through diversification continues to be a staple holding for prudent long-term investors seeking to balance risk and reward.