The investing essentials / 04
Bonds, made understandable.
Learn how lending earns income, why bond prices change, and what to check before investing.
01 / Understand bonds
You’re lending, not owning.
A bond is a loan to an issuer, such as a government or company. Its terms set out interest payments and repayment of principal. Those payments depend on the issuer meeting its obligations.
A stock makes you a part-owner. A bond makes you a lender. Many bonds pay regular interest, called a coupon, and repay their face value at maturity.
Follow a simple bond.
Fictional example · not a current offer
You buy a five-year, fixed-rate bond at its $1,000 face value. Its coupon rate is 5% a year.
The bond’s cash flows
Total received over five years: $1,250 ($250 in coupons plus your $1,000 back).
If all payments are made and the bond is not called early, you receive $50 each year and $1,000 back at maturity.
Illustration assumes annual coupons and excludes fees and taxes. Actual payment schedules and terms vary.
Who issues bonds?
U.S. Treasury: federal government debt.
Municipal issuers: states, cities, and other public entities.
Companies: corporate debt, with credit quality that varies widely.
The issuer’s name alone does not tell you every risk.
Which terms should I learn first?
Face value: the principal due at maturity.
Coupon rate: annual interest as a percentage of face value.
Maturity: when repayment is due.
Market price: what a buyer will pay today.
Face value and market price can differ.
Does every bond pay fixed interest?
No. Some have floating rates or inflation-linked payments. Zero-coupon bonds do not make regular interest payments. This guide’s example uses a fixed-rate coupon bond.
Learn more: SEC’s introduction to bonds ↗
02 / Prices and risks
Fixed income doesn’t mean a fixed price.
When market interest rates rise, existing fixed-rate bond prices generally fall, and vice versa. Credit quality and other factors can move prices, too.
Same coupon. Different current yield.
Illustrative prices · not a forecast
Our bond still pays $50 a year. Change its purchase price to see the current yield:
At the $1,000 face value, current yield equals the 5% coupon rate.
Price and yield sit on a seesaw
Current yield measures coupon income relative to price. It excludes gains or losses at sale or maturity, reinvestment, fees, taxes, and accrued interest. It is not total return or yield to maturity.
Selling early can lock in a loss.
Your sale price may be below what you paid. Higher-duration bonds are generally more sensitive to interest-rate changes.
Repayment can fall short.
An issuer can miss payments or default. Higher yields may compensate investors for taking more credit risk.
Income has other risks.
Inflation reduces purchasing power. A callable bond may be repaid early, leaving you to reinvest at a lower rate. Selling some bonds quickly can also be difficult.
Does a high credit rating guarantee safety?
No. Ratings are opinions about credit risk. They can change and do not remove interest-rate, inflation, or liquidity risk.
How is yield to maturity different?
Yield to maturity accounts for the purchase price, scheduled coupons, and principal repayment. It assumes payments arrive as promised; realizing that compound return also depends on reinvestment assumptions. It is not a guaranteed result.
Further reading: FINRA’s guide to yield and return ↗
03 / Choose your approach
Match the investment to your timeline.
“When will I need the money, and what risks can I accept?”
Use your answer to compare maturities, credit quality, and costs. Then decide whether individual bonds or a fund better fits the job.
Individual bonds: read the terms.
Check maturity, coupon, call provisions, issuer finances, price, yield, and trading costs. Holding to maturity does not eliminate default or inflation risk.
Bond funds: look inside.
A fund spreads money across bonds, but its value and income can fluctuate. Most ordinary bond funds have no single maturity date when your original investment is returned. Check duration, credit quality, holdings, and expenses.
Compare like with like.
Compare similar credit quality and interest-rate exposure. Ask what yield measure is being quoted and whether fees are included. A larger yield is not automatically a better choice.
What is a bond ladder?
A ladder holds bonds with staggered maturities. As bonds mature, their proceeds become available for spending or reinvestment. It can help organize cash flow, but does not remove credit or reinvestment risk.
What should I ask about taxes?
Tax treatment depends on the issuer, security, and account. Do not assume every municipal bond is tax-free for you. Check applicable federal, state, and local rules with a qualified tax professional.
What should I check before placing an order?
Confirm the full purchase cost, including accrued interest where applicable, fees or markups, minimum purchase size, and how you could sell. For a fund, read its prospectus and understand its strategy.