How do bonds work?

Just like people, large organizations — corporations, the federal government, and state and local governments — sometimes need to borrow money. But with them, we’re talking millions, sometimes billions, of dollars.

That’s where bonds come in. How do bonds work?

Whereas stocks are a form of ownership, you can think of bonds as loans. Whenever a large organization needs money — whether to finance operations, expand, or just ensure steady cash flow — it might start selling bonds to the public, usually in increments of $1,000.

In return for your generosity, not only will you get back your initial loan in full, but you’ll also receive interest payments up until then.

How’s that for symbiosis?

Interest payments

When you invest in a bond, you’ll get regular interest payments from the issuer at a set coupon rate, or the amount of interest it pays per year divided by its initial price. For example, if you buy a bond for $1,000 and you receive $100 per year in interest payments, the coupon rate for that bond is 10%.

After you purchase a bond, you’ll continue receiving interest payments — usually semiannually — at that coupon rate until the bond reaches its expiration (maturity) date, which is specified in the bond purchase agreement.

When this date rolls around, the bond issuer will return the initial loan (the principal) to you. Sometimes, however, a company will call its bond, or pay back the principal before the set maturity date. But don’t worry — all bonds will specify whether or not this option is in the cards.

Like maturity dates, coupon rates are also specified in the bond purchase agreement. In general, long-term bonds come with higher coupon rates than do shorter-term bonds. (Note: this doesn’t mean you should just load up on long-term bonds—check out this page for more info.) The type of bond is important, too. Corporate bonds have a face value (original price) of $1,000, but government bonds tend to run much higher.

What are these corporate and government bonds you speak of? We’re glad you asked…

Types of bonds

There are three basic kinds of bonds, each defined by who is selling the debt:

1. Treasuries

These are bonds issued by the federal government. Treasuries come in a variety of different maturities — some take only a few months to mature, while others can take up to 30 years. There are several types of Treasuries: Treasury bills (T-bills) mature in less than one year, Treasury notes mature in 1-10 years, and Treasury bonds take more than 10 years. In the U.S., Treasuries are safe, stable investments – they’re issued by Uncle Sam himself. And if you invest in a Treasury, you don’t have to pay state or local taxes on the interest it pays.

2. Municipal bonds

“Munis” are issued by state and local governments, who try to make them as appealing as possible because unlike the federal government, they run the risk of going bankrupt. Plus, the only other way a state or city can get more income is by raising taxes on its citizens … and that’s never a popular move. So as a purchasing incentive, munis tend to come with high interest payments, and they are free of federal income tax on the interest they pay. Many are exempt from state/local income tax, too.

3. Corporate bonds

These are bonds issued by companies. Corporate bonds are sold much like stocks … through the public securities markets. Like municipal bonds, corporate bonds typically carry higher interest rates because companies want to make them as appealing as possible. High-yield bonds, or junk bonds, are a special type of corporate bond that distributes particularly high interest payments. As the nickname implies, these bonds are often bad news — the interest rates may look great, but the reason they’re so high is that the companies that issue junk bonds are extremely unstable.

Are bonds right for me?

Here at The Motley Fool, we believe that it’s important to build a well-diversified portfolio, one that includes all different kinds of assets — bonds included.

Yes, stocks tend to outperform bonds in the long run. And yes, they are media attention-grabbers. But when it comes to a stable, low-risk investment, bonds are often a good bet.

Unlike stock dividends — which fluctuate as the share price moves up and down — bond interest payments are distributed at regular intervals, so you can count on them for a steady stream of income. Plus, as we discussed above, interest payments from some bonds are exempt from government taxes, which is an especially big selling point for folks in higher tax brackets.

But keep in mind that even though bonds are low-risk investments, they are not totally riskless. While they are usually considered much safer than stocks, bonds can still lose value over time due to factors like price fluctuations and rising rates of inflation. (Investopedia has a great article on this if you’d like to learn more.) To find out how to reduce your risk, check out what our Foolish community has to say, or read Fool Dan Caplinger’s informative article.

For more tips on how to incorporate bonds or other assets into your investment portfolio, head on over to our Foolish rules for asset allocation. And for specifics on the pros and cons of different kinds of bonds, check out our article on where to park your cash. If you’re still left wanting more, visit our Bond Center and click around to your heart’s content.

— Answer provided by Motley Fool intern Caroline Jennings

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