What Is a Bond?

What is a Bond?

A bond is essentially a loan that you make to an entity. When you buy a bond, you are lending money to someone else, and in return they agree to pay you interest and then give you your money back at a later date. That borrower could be a government, a municipality, or a corporation. Instead of you borrowing money from a bank, you are the lender, and the bond issuer is the borrower.

Every bond has a few basic features. The first is the principal, also called the face value. This is the amount of money you lend and expect to get back at the end of the bond’s term. The second feature is the interest rate, often called the coupon. This is the amount the borrower pays you for using your money, usually expressed as a percentage. The third feature is the maturity date, which is the date when the borrower must repay the principal in full.

Bonds are often thought of as safer investments than stocks, but that does not mean they are risk free. One major risk is credit risk, which is the risk that the borrower cannot or will not pay you back. Governments are generally considered safer borrowers than corporations, and large stable companies are usually safer than small or struggling ones. Another important risk is interest rate risk. When interest rates rise, the value of existing bonds tends to fall, and when interest rates fall, the value of existing bonds tends to rise.

There are many different types of bonds. Government bonds are issued by the federal government and are generally considered among the safest investments available. Municipal bonds are issued by states and local governments and are often attractive because the interest may be tax free at the federal level and sometimes at the state level as well. Corporate bonds are issued by companies and usually pay higher interest than government bonds to compensate investors for taking on more risk.

Bonds play an important role in an investment portfolio. They tend to be less volatile than stocks, which means their value usually does not swing as wildly from day to day. This makes them useful for reducing overall portfolio risk and providing more stability, especially as you get closer to needing your money. Bonds can also provide a steady stream of income through regular interest payments.

Many investors do not buy individual bonds but instead invest through bond mutual funds or bond index funds. These funds hold many different bonds, which provides diversification and reduces the impact of any single bond defaulting. Bond funds do not have a maturity date like individual bonds, but they offer convenience and simplicity for most investors.

In short, a bond is a loan you make to a government or company, and in exchange you receive interest and eventually your principal back. Bonds are generally less risky than stocks but still come with important risks that investors need to understand. Used properly, they can be a valuable tool for balancing risk and return in a long term investment plan.