Bonds are loans that investors make to governments or corporations in exchange for scheduled interest payments and the return of the original amount on a set date. When you buy a bond, you become a creditor of the issuer rather than an owner, which is the core difference between a bond and a stock. The issuer is legally obligated to pay you interest on a fixed schedule and repay your principal at maturity. That predictability is why bonds anchor most long-term portfolios and why governments and companies use them to raise large sums without giving up ownership.
Bondholders have no vote in how the organization is run and no claim on its profits. In return, they sit ahead of stockholders if the issuer fails. In a bankruptcy or liquidation, creditors are paid from remaining assets before shareholders receive anything.1eCFR. 12 CFR Part 380 Subpart B – Priorities That legal priority is one reason bonds from a given company are generally considered less risky than its stock, though less risky never means risk-free.
The Numbers That Define a Bond
Every bond comes with a handful of numbers that determine what you’ll earn and when. Learning these lets you compare bonds the way you’d compare mortgage offers.
Par Value
Par value, also called face value, is the amount the issuer promises to pay you when the bond matures. Most corporate and government bonds are issued with a par value of $1,000, though some corporate issues come in $100 or $500 denominations. Par stays fixed for the life of the bond regardless of what happens to its market price, and it’s the base used to calculate interest payments.
Coupon Rate
The coupon rate is the annual interest percentage the issuer pays on par value. A bond with a 5% coupon and a $1,000 par value pays $50 per year in interest, typically split into two semi-annual payments of $25.2MSRB. Interest Payments On a fixed-rate bond, the coupon is locked in at issuance and does not change even if market rates move sharply.
Maturity Date
The maturity date is when the issuer must return your principal. Maturities vary widely. Treasury bills mature in a year or less, while some government and corporate bonds stretch out 30 years.3U.S. Treasury Fiscal Data. Treasury Savings Bonds Explained Longer maturities carry more exposure to changing interest rates and inflation, which is why long-term bonds generally pay higher coupons than short-term ones.
Yield to Maturity
The coupon rate only tells part of the story. Yield to maturity (YTM) is the total annual return you can expect if you buy a bond at its current price and hold it until maturity. It accounts for the coupon payments, the price you actually paid (which may be above or below par), and the time left. Buy a $1,000 par bond for $950 and your YTM will be higher than the coupon rate, because you’ll collect the same interest plus pocket the $50 discount at maturity. YTM is the single best number for comparing bonds with different prices, coupons, and maturities.
Who Issues Bonds
U.S. Treasury Securities
The federal government issues Treasury bills, notes, and bonds to finance national spending. These are backed by the full faith and credit of the United States, meaning the government has pledged to pay principal and interest in full.4Office of the Law Revision Counsel. 31 USC 3123 – Payment of Obligations and Interest on the Public Debt That backing makes Treasuries the benchmark for safety in the bond market. Bills mature in one year or less, notes in two to ten years, and bonds in twenty to thirty years.
The Treasury also offers savings bonds designed for individual investors. Series EE and Series I bonds can be purchased electronically through TreasuryDirect.gov for as little as $25, up to $10,000 per type per calendar year.5TreasuryDirect. How Much Can I Spend/Own Series I bonds adjust for inflation and become more attractive when consumer prices are rising.
Treasury interest is subject to federal income tax but is exempt from state and local income taxes by federal law.6Office of the Law Revision Counsel. 31 USC 3124 – Exemption From Taxation That state exemption matters more than it looks if you live in a high-tax state.
Corporate Bonds
Companies issue bonds to raise capital for expansion, acquisitions, or refinancing existing debt. Public corporate bonds must be registered under the Securities Act of 1933 unless an exemption applies, which requires detailed financial disclosures with the SEC before any sale to the public. In exchange for added credit risk compared to Treasuries, corporate bonds generally offer higher coupon rates. Interest from corporate bonds is fully taxable as ordinary income at the federal level.7Internal Revenue Service. Topic No. 403, Interest Received
Municipal Bonds
State and local governments issue municipal bonds to fund public projects like schools, roads, and water systems. The main draw is tax treatment: interest on most municipal bonds is excluded from federal gross income.8Office of the Law Revision Counsel. 26 USC 103 – Interest on State and Local Bonds For investors in the higher federal brackets, the after-tax yield on a muni can beat a higher-coupon corporate bond.
Common Variations You’ll See
The standard fixed-rate bond is the most common type, but several variations change how your returns are calculated or when your investment might end.
Treasury Inflation-Protected Securities
TIPS address the problem of inflation eroding fixed payments. The principal of a TIPS adjusts up with inflation and down with deflation, based on the Consumer Price Index. Because interest is applied to the adjusted principal, your dollar payments rise when prices rise.9TreasuryDirect. Treasury Inflation-Protected Securities (TIPS) At maturity, you receive either the inflation-adjusted principal or the original principal, whichever is greater, so deflation can’t reduce your payout below what you started with.
Callable Bonds
A callable bond gives the issuer the right to pay you back early, usually after a specified date. Issuers typically call bonds when interest rates have dropped, because they can retire the old debt and issue new bonds at a lower rate.10Investor.gov. Callable or Redeemable Bonds When a bond is called, you receive the face value (sometimes with a small call premium) plus accrued interest, but your stream of above-market coupon payments stops. To compensate for this, callable bonds generally offer higher coupon rates than non-callable bonds of similar credit quality.
Convertible Bonds
Convertible bonds are corporate bonds that can be exchanged for a set number of shares of the issuer’s stock. You get the downside protection of a bond with the option to participate in the stock’s upside if the company performs well. The trade-off is a lower coupon rate than a comparable non-convertible bond, since the conversion feature has value built in.
Zero-Coupon Bonds
Zero-coupon bonds pay no periodic interest. Instead, they’re sold at a steep discount to par value, and you receive the full face value at maturity. The difference between what you paid and par is effectively your interest, earned all at once.
One tax trap catches investors every year: zero-coupon bonds and other deep-discount bonds generate what the IRS calls original issue discount (OID). You owe tax on OID as it accrues each year, even though you won’t receive any cash until maturity.11Internal Revenue Service. Guide to Original Issue Discount (OID) Instruments That phantom income is why zero-coupon bonds are often held in tax-advantaged accounts like IRAs, where the annual bill is not an issue.
Credit Ratings
Not all bonds carry the same risk of the issuer failing to pay. Credit rating agencies assign letter grades to issuers based on their financial strength and likelihood of default. Higher grades mean lower risk.
The critical dividing line is between investment grade and speculative grade, commonly called junk or high yield. On the S&P and Fitch scales, anything rated BBB- or above is investment grade; BB+ and below is speculative. Moody’s uses a parallel system: Baa3 and above is investment grade, Ba1 and below is speculative. Within those buckets, ratings run from AAA at the top down through various A and B levels to C and D at the bottom, where default is either imminent or has already occurred. Speculative-grade bonds pay significantly higher coupons because the risk of not getting all your money back is real.
Risks of Owning Bonds
Bonds are often described as safe investments, and compared to stocks they generally are. But safer does not mean no risk, and the risks that do exist can surprise investors who treat bonds as a parking spot for cash.
Interest Rate Risk
Bond prices and market interest rates move in opposite directions. When rates rise, existing bonds with lower coupons become less attractive and their market price drops. When rates fall, existing bonds become more valuable because their locked-in coupons look generous. The effect is larger on longer maturities. A 30-year bond’s price swings far more in response to a rate change than a 2-year bond’s price does. If you hold until maturity, day-to-day price moves don’t affect your return. If you sell early in a rising-rate environment, you may get back less than you paid.
Credit Risk
Credit risk is the chance that the issuer can’t make its interest payments or return your principal. The risk is negligible for U.S. Treasuries and very real for lower-rated corporate bonds. Ratings help you gauge this risk before you buy, but ratings can change. A downgrade from investment grade to junk status can cause a bond’s price to drop sharply even if the issuer hasn’t missed a payment.
Inflation Risk
A fixed coupon that looks attractive today may not keep pace with rising prices over a 10- or 30-year period. If inflation runs at 4% and your bond pays 3%, your purchasing power shrinks every year. TIPS address this directly. Standard fixed-rate bonds offer no built-in protection.
Call Risk
If you own a callable bond and rates drop, the issuer is likely to call it and refinance at a lower rate. You get your principal back, but now have to reinvest it in a market where available rates are lower than what you were earning.10Investor.gov. Callable or Redeemable Bonds This reinvestment problem is the main reason callable bonds pay higher coupons.
How to Buy Bonds
The buying process depends on what type of bond you want. For savings bonds, the only option is TreasuryDirect.gov, where you can open a free account and purchase Series EE or Series I bonds electronically for any amount between $25 and $10,000.12TreasuryDirect. Buying Savings Bonds Marketable Treasury securities (bills, notes, and bonds) can also be bought through TreasuryDirect at auction or on the secondary market through a brokerage account.
Corporate and municipal bonds are purchased through brokerage firms. Most major online brokers offer screening tools that let you filter by credit rating, maturity, yield, and issuer type. Liquidity varies widely. Recently issued bonds from large corporations trade actively, while older or smaller municipal issues can be harder to buy or sell without accepting a wider markup from the broker.
Many investors access the bond market through bond mutual funds or exchange-traded funds rather than buying individual bonds. Funds offer instant diversification across hundreds of issuers, professional management, and easy buying and selling. The trade-off is that bond funds have no maturity date. An individual bond converges toward par value as maturity approaches, but a fund’s share price fluctuates indefinitely because the manager is constantly buying and selling bonds inside the portfolio. If interest rates rise sharply, a bond fund’s value can drop and stay down in ways that would not affect an individual bond you planned to hold to maturity. The choice comes down to whether you value the certainty of a known payout date or the convenience and diversification of a fund.