What Is a Bond and How Do You Invest in Them?

A bond is a loan you make to a company or government in exchange for regular interest payments and your money back, called the face value, when the bond matures. That predictable income is why bonds are often seen as steadier than stocks. But they carry three main risks: interest rate risk, credit risk, reinvestment risk and inflation risk. Here’s how bonds work, why prices fall when interest rates rise, and how to buy them.

For help with your own investment portfolio, consider talking to a financial advisor.

What Is a Bond?

A bond is a type of investment in which you, as the investor, loan money to a borrower, with the expectation that you’ll get your money back with interest after your term length expires. Bonds are a type of fixed-income investment, which means you know the return that you’ll get before you purchase. Bonds can be issued, meaning put up for sale, by the federal and state governments as well as companies.

Bonds are one of two ways you can invest in a business. The other is to buy a company’s stock. While bonds are debt investments in which a company borrows money from investors, stocks are equity investments that represent ownership in a company.

How Do Bonds Work?

When you buy a bond, you’re lending money to the entity that issued the bond, whether that’s a company or a government. Since you’re lending, that means you’re entitled to collect interest. When the bond matures, you’ll get back the money you paid for the bond, known as the principal or the par value, and you’ll also get interest on top of it.

When you’re shopping for bonds, you’ll be able to see each bond’s price, time to maturity and coupon rate. The coupon rate is the annual interest you’ll receive, expressed as a percentage of the principal that you pay to buy the bond. Coupon rates for new bonds hover around the market interest rate.

So, if you purchase a two-year bond with a par value of $1,000 and a coupon rate of 4%, then you would earn $40 in interest for each year of the term and $80 in total interest. Most bonds will pay out interest twice a year on what are called coupon dates. This is fairly straightforward, but things get more interesting when we think about reselling these bonds on the secondary market.

Understanding the Bond Market

The bond market is sensitive to fluctuations in the interest rate. What do we mean by “the” interest rate? There are lots of different interest rates, for things like home mortgages and credit cards, but when someone refers to “the interest rate” or “interest rates” in a general way, they’re referring to the interest rate set by the Federal Reserve. This is also known as the federal funds rate.

The Fed uses its power to buy and sell Treasury Bonds to affect interest rates. When the Fed sells Treasury Bonds, it’s taking money that would otherwise circulate in the economy. Cash becomes more scarce, which makes borrowing money relatively more expensive and therefore raises interest rates. Interest rates are the cost of borrowing money. The interest rate that the Fed decides on as a target has a knock-on effect on other interest rates, including your mortgage rate and the rates on bonds.

When the general interest rate goes up, the price of existing bonds falls. In other words, interest rates and bond prices have an inverse relationship. Think of it this way: If interest rates rise, new bonds that are issued will have a higher interest rate to reflect this change. If you go to sell a bond that has the old, lower interest rates, you’ll have to lower its price to get anyone to buy it. That’s because the opportunity cost of holding your old, lower-coupon-rate bond has risen.

What Are the Risks of Investing in Bonds?

Although bonds are generally considered less risky than stocks, they still carry risks that investors should understand. Four of the most common are interest rate risk, credit risk, reinvestment risk and inflation risk.

Interest Rate Risk

Interest rate risk refers to the possibility that changes in market interest rates will affect a bond’s value. When interest rates rise, the market value of existing bonds generally falls because newly issued bonds may offer higher yields. As a result, investors who sell their bonds before maturity could receive less than they originally paid.

Interest rate risk affects both short-term and long-term bonds, although bonds with longer maturities are typically more sensitive to rate changes. However, fluctuations in market value may be less concerning if you plan to hold a bond until maturity. In that case, you’ll generally receive its full face value when it matures, provided the issuer meets its repayment obligations.

Credit Risk

Credit risk is the possibility that a bond issuer, whether a company or government, will fail to make scheduled interest payments or repay the principal. Credit rating agencies assess the creditworthiness of bond issuers and individual bonds to help investors evaluate this risk.

Bonds with lower credit ratings, often called “junk bonds,” typically offer higher yields to compensate investors for their greater risk of default. U.S. Treasury bonds, by comparison, are generally considered to have very low credit risk, although they remain subject to interest rate risk.

Inflation Risk

Bonds are also exposed to inflation risk, which occurs when rising prices reduce the purchasing power of your investment returns. For example, if a bond pays 2% annually while inflation is 2.4%, your investment is losing purchasing power even though you’re earning interest.

This can be particularly concerning for investors holding fixed-rate bonds over long periods. While bonds may provide a relatively stable source of income, their returns aren’t always enough to keep pace with inflation.

Reinvestment Risk

Reinvestment risk is the possibility that you’ll have to reinvest money from a bond at a lower interest rate than you originally earned. This can happen when market interest rates decline, leaving investors with fewer opportunities to earn comparable returns on their money.

For example, if you own a bond paying 5% interest and market rates fall to 3%, you may only be able to reinvest your interest payments at the lower rate. The same risk applies when a bond matures or is called before maturity, requiring you to find a new investment. While falling interest rates generally increase the market value of existing bonds, they can make it harder to maintain the same level of investment income over time.

How to Buy Bonds

You can buy Treasury bonds directly from the US Treasury through its site, Treasury Direct. To buy other types of bonds, including municipal bonds and corporate bonds, you’ll go through a brokerage. This could be an online-only brokerage that charges a fee per trade, a brokerage firm that charges low fees as a percentage of your assets or a full-service brokerage that charges higher fees but offers more in the way of financial advice.

You can also buy bond mutual funds, bond ETFs and bond index funds. Bond funds will hold various bonds in pursuit of higher returns and diversification. A Bond ETF trades on the market and offers different tax advantages to bond mutual funds. Bond index funds charge lower fees because they’re passively managed as opposed to actively managed. They aim to mirror or “index” the overall bond market.

There are also mortgage bonds, backed by real estate mortgages. These are the mortgage-backed securities (MBSs) that became notorious during the financial crisis. Many mortgage bonds are dependable investments, but others are based on mortgages with a high risk of default. In other words, choose wisely.

Bottom Line

A bond with a high rating offers dependability and certainty. But in the investing world, lower risk tends to mean lower return. That’s why bonds don’t offer the kinds of returns you’ll get if you invest in stock. The lower volatility of bonds means that most investors choose to balance their portfolio with a mix of bonds and stocks. The closer you are to retirement, the less time you have to weather ups and downs in the stock market.

Investing Tips

A financial advisor can help you evaluate how bonds and other investments may fit into your portfolio and broader financial goals. Finding a financial advisor doesn’t have to be hard. SmartAsset’s free tool matches you with vetted financial advisors who serve your area, and you can have a free introductory call with your advisor matches to decide which one you feel is right for you. If you’re ready to find an advisor who can help you achieve your financial goals, get started now.
Bond investing is a great way to adjust the risk tolerance of your overall portfolio, but it can be tricky to find the exact balance you want. SmartAsset’s asset allocation calculator can help you understand how risk tolerance influences your investing decisions.