A bond is a loan from an investor to a borrower, packaged as a tradable security. When you buy a bond, you hand the issuer a lump sum. In exchange, the issuer contractually promises to pay you interest on a set schedule and return your principal on a specific future date. That is the whole idea. The bond loan definition most people are looking for is simply this: a bond is a formal IOU that a government or company sells to raise money, and the buyer of that IOU is the lender.
What makes a bond different from a handshake loan or a mortgage is that it is designed from the start to be sold in pieces to many lenders at once, and to change hands after it is issued.
The Three Numbers That Define the Loan
Every bond contract is built around three figures.1Investor.gov. Bonds
The face value, also called par value, is the amount the issuer owes you at the end. It is typically $1,000 per bond. That is the number the borrower repays when the loan comes due.
The coupon rate is the annual interest rate the issuer pays on that face value. A 5% coupon on a $10,000 bond produces $500 a year in interest, usually paid in two installments of $250 six months apart.2Municipal Securities Rulemaking Board. Interest Payments
The maturity date is when the loan ends. On that date, the issuer sends the final interest payment and returns the full face value. The debt is then extinguished.
Once you know those three numbers, you know almost everything about what the loan will pay you if you hold it to the end.
Who Is Involved in the Loan
Three parties do most of the work. The issuer is the borrower raising money. The investor is the lender buying the bond. Between them sits an underwriter, usually an investment bank, that buys the full bond issue from the borrower and resells it to investors. The underwriter guarantees the issuer receives its capital even if the bonds take time to place.
For publicly offered corporate bonds, federal law also requires the issuer to appoint a trustee, typically a bank, to monitor compliance with the deal on behalf of bondholders. The deal itself is written into a document called the bond indenture, a legal contract that spells out the coupon rate, maturity date, any restrictions on what the issuer can do while the debt is outstanding, and what happens if the issuer defaults.3Legal Information Institute. Wex Definition – Indenture The indenture is what turns “we owe you money” into an enforceable loan agreement.
How a Bond Differs From a Bank Loan
Bonds and bank loans are both debt, but they operate very differently.
A bank loan is a private arrangement between a borrower and one lender, or a small group of lenders. The terms are negotiated directly, and the loan generally stays on the bank’s books until it is repaid.
A bond splits the same idea into standardized, tradable pieces. A company issuing $500 million in bonds might sell to thousands of investors at once. Each investor holds a slice of the total debt and can sell that slice to someone else on the secondary market at any time.
That tradability is the practical reason bonds exist. A bank holding a loan has to wait for repayment or go through a complicated transfer process to move the debt. A bondholder who needs cash can sell on the open market, often the same day. Because that liquidity makes the debt more attractive to lenders, large borrowers can generally get lower interest rates by issuing bonds than by borrowing the same amount from a single bank.
Types of Bonds by Borrower
The identity of the borrower drives almost everything about the loan: how safe it is, how much it pays, and how the interest is taxed.
Corporate Bonds
Companies issue corporate bonds to fund operations, expansions, or acquisitions. They pay higher interest than government bonds because they carry real credit risk. Rating agencies grade that risk with letter scores. Bonds rated BBB or higher by Standard & Poor’s, or Baa and above by Moody’s, are considered investment-grade. Anything below is labeled high-yield or “junk,” pays more interest, and defaults more often.4FINRA. Bonds Interest from corporate bonds is taxed as ordinary income at both the federal and state level.5Internal Revenue Service. Topic No. 403, Interest Received
Municipal Bonds
State and local governments issue municipal bonds to pay for public projects like schools, roads, and water systems. The appeal is tax treatment: interest is generally exempt from federal income tax, and often from state and local taxes as well, especially for residents of the issuing state.6Municipal Securities Rulemaking Board. Municipal Bond Basics
Municipal bonds come in two forms. General obligation bonds are backed by the taxing power of the government that issued them. Revenue bonds are backed only by the income from a specific project, such as a toll road or an airport, and typically pay a bit more interest because the repayment depends on that project generating money.6Municipal Securities Rulemaking Board. Municipal Bond Basics
U.S. Treasury Securities
The federal government borrows through several instruments issued by the U.S. Department of the Treasury, sorted by how long the loan runs:
- Treasury Bills (T-Bills) mature in 4 to 52 weeks. They pay no periodic interest; you buy them at a discount and receive the full face value at maturity.
- Treasury Notes (T-Notes) run 2, 3, 5, 7, or 10 years and pay interest every six months.
- Treasury Bonds (T-Bonds) run 20 or 30 years and also pay semiannual interest.
- TIPS (Treasury Inflation-Protected Securities) run 5, 10, or 30 years. The principal adjusts up with inflation and down with deflation based on the Consumer Price Index, and at maturity you receive the higher of the adjusted principal or the original face value.
7TreasuryDirect. About Treasury Marketable Securities8TreasuryDirect. Treasury Inflation-Protected Securities (TIPS)
Treasuries are considered the safest bonds because they are backed by the full faith and credit of the U.S. government, and the trade-off is lower yields than corporate or municipal debt.1Investor.gov. Bonds Treasury interest is subject to federal income tax but exempt from state and local income taxes.9TreasuryDirect. Tax Information for EE and I Savings Bonds
What the Lender Risks
Bonds are steadier than stocks, but they are not risk-free. Four risks matter most.
Credit risk is the chance the issuer fails to make interest payments or return the principal. This is the central risk for corporate and lower-rated municipal bonds, and the weaker the borrower’s finances look, the higher the coupon it has to offer to attract lenders.1Investor.gov. Bonds
Interest rate risk shows up if you sell before maturity. Bond prices and market rates move in opposite directions: when rates rise, your existing bond becomes less attractive than newly issued bonds paying more, and its market price falls. The longer the maturity, the bigger the swing. This sensitivity is captured by a measure called duration; the higher the duration, the larger the price move when rates change.10FINRA. Brush Up on Bonds – Interest Rate Changes and Duration Hold to maturity and you get your full face value back regardless of what happened to prices along the way.
Inflation risk eats at fixed payments. A bond paying 3% while inflation runs 4% loses purchasing power every year, and the face value returned at maturity buys less than the money you lent. TIPS are the built-in defense against this.1Investor.gov. Bonds
Call risk applies when the bond includes a call provision letting the issuer pay you back early. Issuers call bonds when interest rates drop so they can refinance cheaper, which forces you to reinvest in a lower-rate environment. Callable bonds usually offer a slightly higher coupon to compensate. If you are looking at one, the number to check is the yield-to-call, which assumes the issuer redeems at the earliest allowed date and gives you the more conservative picture of your return.11FINRA. Callable Bonds – Be Aware That Your Issuer May Come Calling
What Happens if the Borrower Defaults
A bond default does not mean bondholders walk away with nothing. In a corporate bankruptcy, bondholders rank ahead of stockholders in the line for whatever assets remain. Stockholders are last, and often receive nothing.12U.S. Securities and Exchange Commission. Saving and Investing
Among bondholders themselves, seniority controls the payout order. Senior secured bondholders, whose claims are backed by specific company assets, get paid first. Senior unsecured bondholders come next. Subordinated, or junior, bondholders are paid only after the senior claims are satisfied. In a Chapter 11 reorganization, the court must classify all claims and specify how each class will be treated before a restructuring plan can move forward, and bondholders whose claims are impaired are entitled to vote on the plan.13United States Courts. Chapter 11 Bankruptcy Basics
Recoveries vary widely. Senior secured bondholders in a corporate default may get back 50 cents on the dollar or more, while subordinated bondholders can end up with far less. That hierarchy is why senior bonds carry lower yields: the lender is accepting a smaller return in exchange for a better place in line if the loan goes bad.