Introduction
Bonds allow governments, companies, and other organizations to borrow money directly from investors. When you buy a bond, you are generally lending money to the issuer under a set of agreed terms rather than buying part of the organization.
Those terms can include interest payments, a maturity date, and the amount the issuer is expected to repay. Although bonds are often viewed as more conservative than stocks, their prices can change and investors can lose money.
Understanding the basic mechanics of bonds makes it easier to evaluate bond yields, compare different issuers, and recognize the risks involved.
What is a bond?
A bond is a debt security. The organization borrowing the money is known as the issuer, while the person or institution buying the bond becomes a creditor of that issuer.
Unlike a shareholder, a bondholder does not normally receive an ownership stake in the issuer. Instead, the bond represents a contractual obligation that describes how and when the issuer will make payments.
Bonds can be issued by the U.S. Treasury and other governments, municipalities, corporations, and various public or private organizations.
Key parts of a bond
Face value
The face value, also called par value, is the amount the issuer generally agrees to repay at maturity. Many bonds are quoted relative to this amount.
Coupon
The coupon determines the bond’s stated interest payments. Some bonds pay fixed coupons, while others use variable rates or do not make periodic coupon payments.
Maturity
The maturity date is when the bond comes due and the issuer is generally expected to repay its face value, assuming it has not defaulted.
Market price
After issuance, many bonds can trade above or below face value. Their prices respond to interest rates, credit conditions, time to maturity, and supply and demand.
How a bond works
Consider a simplified bond with a $1,000 face value, a 5% annual coupon rate, and a five-year maturity. If the bond pays its coupon annually, the stated interest payment would be $50 per year. At maturity, the issuer would also be expected to repay the $1,000 face value.
If an investor buys that bond for exactly $1,000 and holds it to maturity, the cash flows are straightforward, provided the issuer makes all promised payments. In the real market, however, an investor may pay more or less than $1,000 for the bond.
That purchase price matters because it changes the investor’s effective return. This is why a bond’s coupon rate should not be confused with its yield.
Why bond prices change
One of the most important forces affecting fixed-rate bonds is the level of market interest rates. Suppose newly issued bonds with similar risk begin offering higher interest rates. An older bond paying a lower fixed coupon becomes less attractive, so its market price may need to fall to compete.
The reverse can happen when market rates decline. An existing bond with a relatively high fixed coupon may become more attractive, causing its price to rise.
Bond prices can also change when investors become more or less confident that an issuer will repay its debt. A deterioration in credit quality can push a bond’s price lower even if general interest rates have not changed.
Why organizations issue bonds
Issuing bonds gives borrowers access to capital without selling an ownership stake. Governments can use bond proceeds to finance public spending and manage their funding needs. Companies may issue bonds to fund expansion, acquisitions, capital investments, or refinance existing debt.
Borrowing through bonds comes with obligations. The issuer must make the payments required by the bond’s terms, and taking on too much debt can increase financial risk.
Government bonds vs corporate bonds
| Feature | Government bonds | Corporate bonds |
|---|---|---|
| Issuer | National, state, or local government entities | Companies |
| Purpose | Finance government activities and funding needs | Finance business activities and refinance debt |
| Credit risk | Varies by government issuer | Varies by the financial strength of the company |
| Yield | Depends on issuer, maturity, rates, and market conditions | Often includes additional compensation for corporate credit risk |
Neither category is a single level of risk. Learn more in our guides to government bonds and corporate bonds.
Why investors buy bonds
Bonds are commonly used to generate interest income, preserve capital under certain conditions, and diversify portfolios. Because high-quality bonds may behave differently from stocks, combining the two can help spread investment risk.
Some investors also use bonds to match future financial needs with known maturity dates. However, the reliability of those future cash flows depends on the issuer’s ability to make its promised payments.
Main risks of bonds
Bonds can lose value for several reasons. Rising interest rates can reduce the market price of existing fixed-rate bonds. An issuer’s weakening finances can increase credit risk. Inflation can reduce the purchasing power of fixed future payments, and some bonds may be difficult to sell quickly without accepting a lower price.
Longer maturities and lower credit quality can increase certain risks, although the exact risk profile depends on the bond. Our bond risks guide covers these factors in more detail.
Key takeaways
- A bond is a debt security through which an investor lends money to an issuer.
- Important bond terms include face value, coupon, maturity, and market price.
- Bondholders are generally creditors rather than owners of the issuer.
- A bond can trade above or below its face value before maturity.
- Bond prices are influenced by interest rates, credit quality, maturity, and market conditions.
- Bonds can provide income and diversification, but investors still face the possibility of losses.