Bonds Definition, How They Work, Terms, Types

If you are wondering how to buy bonds, investors can invest in bonds by buying new issues, purchasing bonds on the secondary market, or buying bond mutual funds or exchange-traded funds (ETFs). However, the original bond becomes more valuable if interest rates drop and similar bonds get listed for a 3% coupon. As a result, investors who want a better coupon rate will have to pay more for the security to incentivize the original bondholder to sell. The inflated value will bring the bond’s total yield down to 3% for new investors since they will have to pay an amount higher than the par value to acquire the bond.

Although bonds carrying these ratings are deemed speculative investments, they attract particular investors drawn to the high yields they offer. These bonds come with “AAA” to “BBB-“ratings from Standard and Poor’s and “Aaa” to “Baa3” ratings from Moody’s. Treasury bonds (T-bonds) are the most common AAA-rated bond securities.

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You can research and choose bonds individually, but we suggest that you consider having most of your bond portfolio be made up of mutual funds or ETFs (exchange-traded funds). If interest rates rise, fewer people will refinance and you (or the fund you’re investing in) will have less money coming in that can be reinvested at the higher rate. If interest rates fall, refinancing will accelerate and you’ll be forced to reinvest the money at a lower rate. Because mortgages can be refinanced, bonds that are backed by agencies like GNMA are especially susceptible to changes in interest rates. The families holding these mortgages may refinance (and pay off the original loans) either faster or slower than average depending on which is more advantageous.

1. When you invest in a bond, you are a debtholder for the entity that is issuing the bond.
2. The entity repays individuals with interest in addition to the original face value of the bond.
3. There is also interest rate risk, where bond prices can fall if interest rates increase.

Bonds are financial instruments that investors buy to earn interest. Essentially, buying a bond means lending money to the issuer, which could be a company or government entity. The bond has a predetermined maturity date and a specified interest rate.

Our work has been directly cited by organizations including Entrepreneur, Business Insider, Investopedia, Forbes, CNBC, and many others. Our team of reviewers are established professionals with decades of experience in areas of personal finance and hold many advanced degrees and certifications. If the same bond were to be sold for $900, the yield would be 5.5%.

Bonds that have a very long maturity date also usually pay a higher interest rate. This higher compensation is because the bondholder is more exposed to interest rate and inflation risks for an extended period. Bonds are generally considered safe, particularly those of investment grade, but they do carry risks. Interest rate risk affects bond prices negatively when interest rates rise, diminishing the appeal of older bonds. Reinvestment risk emerges when bond income has to be reinvested at a lower return. Additionally, call risk arises when issuers prematurely redeem bonds, possibly leading to lower future interest payments.

Although the income from a municipal bond fund is exempt from federal tax, you may owe taxes on any capital gains realized through the fund’s trading or through your own redemption of shares. For some investors, a portion of the fund’s income may be subject to state and local taxes, as well as to the federal Alternative Minimum Tax. A type of investment that pools shareholder money and invests it in a variety of securities. Each investor owns shares of the fund and can buy or sell these shares at any time. Mutual funds are typically more diversified, low-cost, and convenient than investing in individual securities, and they’re professionally managed. You’ll have to pay federal income tax on interest from these bonds, but the interest is generally exempt from state tax.

What Determines a Bond’s Coupon Rate?

All investing is subject to risk, including the possible bonds meaning in finance loss of the money you invest. Diversification does not ensure a profit or protect against a loss. The degree of fluctuation in the value of a security, mutual fund, or index, volatility is often expressed as a mathematical measure such as a standard deviation or beta. The greater a fund’s volatility, the wider the fluctuations between its high and low prices.

Part 3: Confidence Going Into Retirement

The lower a bond’s ratings, the more interest an issuer has to pay investors in order to entice them to make an investment and offset higher risk. When an investor looks into corporate bonds, they should weigh out the possibility that the company may default on the debt. Safety usually means the company has greater operating income and cash flow compared to its debt.

Bonds are relatively safe and can create a balancing force within an investment portfolio focused on stocks by diversifying the portfolio’s assets and lowering its overall risk. Bonds that are riskier pay higher rates in exchange for the investor giving up some safety. Bond prices are determined based on factors such as interest rates, supply vs. demand of bonds, inflation, and credit risk. You also may be able to buy bond funds through your brokerage account.