What are Bonds? Understanding Bond Types and How They Work

Wondering about bonds? They're well worth considering when building out your investment portfolio. They come with many potential benefits, including capital preservation, diversification, income, and potential tax advantages.

Ahead, we'll answer the most important questions about bonds. Read through them all or jump around:

• What is a bond?
• How do bonds work? 
• What are bond ratings?
• What are the most common types of bonds?
• What are the risks associated with bonds?
• How can I buy bonds?

A bond is a loan. When you purchase a bond, you provide a loan to an issuer, like a government, municipality, or corporation. In return, the issuer promises to pay back the money it borrowed, with interest. The interest will be received on a predetermined schedule (usually semiannually, but sometimes annually or quarterly).

Here's an example of how a bond works: Let's say the government issues a 10-year bond with a face value (a.k.a. par value) of $10,000 and an annual interest rate of 4%, paid semiannually. When you buy this bond, you're lending the government $10,000. Every year for the next ten years, the government will owe you 4% of that $10,000 ($400 annually or $200 every 6 months) as an interest payment, also known as a coupon payment. In addition to the $400 coupon payment you receive yearly, the government will also have to pay you back the full $10,000 when the bond matures (in this case, at the 10-year mark). 

Bonds are generally issued with fixed par values and stated coupon rates. The coupon rate determines the annual interest payments to be paid to the bondholder and are based off of the bond's par value. Interest payments are usually paid every six months.

While the par value of a bond is usually fixed, prices can still fluctuate in the secondary market. Bond prices and yields move in opposite directions. When interest rates rise, prices tend to fall, and vice versa. This can affect the market value of a bond if you decide to sell it before it reaches maturity. 

A bond term refers to the length of time between the date the bond was issued and when the bond matures. Bonds with terms of less than four years are considered short-term bonds. Bonds with terms of 4 to 10 years are considered intermediate-term bonds. Bonds with terms of more than 10 years are considered long-term bonds.

Major rating agencies like Moody's Investors Service (Moody's) and Standard & Poor's (S&P) issue a credit rating for bonds. Bond ratings represent the rating agencies' opinion of the issuer's creditworthiness and ability to repay its debt, based on its financial position, management, and other factors.

The ratings are the opinion of the agency. They are not a guarantee of credit quality, probability of default, or recommendation to buy or sell. Ratings reflect a current assessment of an issuer's creditworthiness and do not guarantee performance now or in the future. Issuers rated below investment grade are expected to have a greater risk than those with investment grade credit ratings.

Let's look at the different types of bonds, starting with the types of bonds that could make up the core of your bond portfolio. Core bonds can help offer diversification, stability, and a reliable source of income.

Core bonds include:

• U.S. Treasuries
• Municipal bonds
• Investment-grade corporate bonds
• Mortgage-backed securities
• Treasury Inflation-Protected Securities
• Agency bonds

Sometimes it makes sense to assume more risk in exchange for higher yields—and that's where aggressive income bonds come in. Aggressive income bonds should generally make up only a small portion of your total portfolio to minimize unnecessary risk.

Aggressive income bonds include:

• High-yield corporate bonds
• International developed market bonds
• Emerging-market bonds
• Preferred securities

Treasuries are issued by the U.S. government and come in three varieties:

• Treasury bills mature in up to 52 weeks and do not make coupon payments. Rather, they are sold for less than their face value but pay their full face value at maturity. The interest earned is the difference between the purchase price and the par value at maturity.
• Treasury notes are issued with maturities of two, three, five, seven, or 10 years and pay interest every six months.
• Treasury bonds are issued with 20- and 30-year maturities and pay interest every six months.

U.S. Treasuries are considered among the safest available investments because of the very low risk of default. Unfortunately, this also means they have among the lowest yields, even if interest income from Treasuries is generally exempt from local and state income taxes.

Municipal bonds, or munis, are issued by states and other local governments to fund public projects and services, such as roads and schools. They generally fall into one of two categories:

• General obligation (GO) bonds are backed by the taxing authority of an issuing municipality. Most municipal bonds are highly rated, however, and municipal default rates tend to be very low.
• Revenue bonds, which account for nearly two-thirds of investment-grade municipal bonds, are backed by revenue from a specific source, such as a toll road or public utility—meaning your principal and/or interest payments are supported by a steady income stream.

Interest earned on most municipal bonds is exempt from federal income tax and may be exempt from state and local taxes (depending on where you live). Because of those tax advantages, municipal bonds typically offer lower yields than investment-grade corporate bonds.

Investment-grade corporate bonds are issued by companies with credit ratings of Baa3 or BBB- or above by Moody's or S&P, respectively, and therefore have a relatively low risk of default. Companies issue corporate bonds to raise capital for a number of reasons, such as expanding operations, purchasing new equipment, building new facilities, or just for general corporate purposes.

The issuing company is responsible for making interest payments (usually semiannually, but sometimes monthly or quarterly) and repaying the principal at maturity. Investment-grade corporates carry a higher risk of default than Treasuries and municipal bonds, and therefore offer a slightly higher yield.

Mortgage-backed securities are created by pooling mortgages purchased from the original lenders. Investors receive monthly interest and principal payments from the underlying mortgages. These securities differ from traditional bonds in that there isn't necessarily a predetermined amount that gets redeemed at a scheduled maturity date.

Bondholders receive monthly payments that are made up of both interest and part of the principal as borrowers pay back their loans. These payments can vary from month to month and create irregular cash flows. Additionally, prepayment of mortgages can cause mortgage-backed securities to mature early, cutting short an investor's income stream.

Treasury Inflation-Protected Securities (TIPS) are a type of Treasury security whose principal value is indexed to inflation. When inflation rises, the TIPS' principal value is adjusted up. If there's deflation, then the principal value is adjusted lower. Like U.S. Treasuries, TIPS are backed by the full faith and credit of the U.S. government. Interest is paid based on the adjusted principal every six months, and at maturity, investors receive either the original or adjusted principal—whichever is greater.

U.S. agency bonds are issued by government-sponsored enterprises (GSE), and the bonds are guaranteed by the issuing agency, not the full faith and credit of the U.S. government. Since they get implicit support from the U.S. government, they are considered to be of high credit quality. Issuers of agency bonds include the Federal National Mortgage Association (Fannie Mae) and Federal Home Loan Mortgage Corporation (Freddie Mac).

High-yield corporates are issued by companies with credit ratings of Ba1 or BB+ or below by Moody's and S&P, respectively, and therefore have a relatively higher risk of default. They are also called "junk bonds." To compensate for that added risk, they tend to pay higher rates of interest than those of their higher-quality peers.

International developed market bonds, also known as foreign bonds, are issued by either a foreign government or foreign corporation in a foreign currency. Developed market bonds tend to have higher credit ratings than emerging market bonds, but they still have varying degrees of economic, political, and social risks. Additionally, investing internationally carries currency risk.

International emerging market bonds (EM bonds) are issued by a government, agency, municipality, or corporation domiciled in a developing country. These investments typically offer higher yields to reflect the elevated risk of default, which can stem from underlying factors such as political instability, poor corporate governance, and currency fluctuations. The asset class is relatively new compared with other sectors of the bond market. EM bonds may be denominated in local currency, U.S. dollars, or other hard currencies.

Preferred securities are considered a hybrid investment, as they share the characteristics of both stocks and bonds. Like bonds, they generally have fixed par values—often just $25—and make scheduled coupon payments. Preferred securities often have very long maturities, or no maturity date at all, meaning they are "perpetual", but they can generally be redeemed by the issuer after a certain amount of time has passed. Like stocks, however, preferred securities generally rank below an issuer's bonds, and their dividends are often (but not always) discretionary. While a missed payment by a bond generally triggers a default, that's not necessarily the case with preferred securities, although it varies by issue. Given the increased risks and their complex characteristics, preferred securities tend to offer relatively high yields.

Bond investing comes with a number of risks, but interest rate risk and credit risk are two of the main risks. Here's a look at some risks that can come with bond investing.

Interest rate risk is the risk that a bond's value will fall as interest rates rise. Bond prices and yields move in opposite directions, so when yields are rising, bond values tend to fall in the secondary market. You risk losing principal if you need to sell your bond before it matures, potentially at a lower price than what you paid for it or for what its par value is.

Credit risk is the risk that a security could default if the issuer fails to make timely interest or principal payments. Downgrade risk is also a form of credit risk, as a downgrade in a bond's credit rating could result in a lower price in the secondary market.

Some bonds are sold with a call provision that gives the issuer the option to redeem, or "call", the security after a specified about of time has passed. The bond can usually be called at a specified price—typically its par value. Callable bonds are more likely to be called when interest rates fall and the issuer can issue new bonds with a lower interest rate. If your bond is called, you will likely have to reinvest the proceeds at a lower interest rate than the original security's rate. This can lead to a reduction in annual interest payments, effectively resulting in less income.

Inflation risk, also known as purchasing power risk, refers to the risk that you could lose purchasing power if inflation picks up. Most bond investments make fixed interest payments, meaning they won't change even if prices elsewhere are rising.

Liquidity risk is the measure of how easily a security can be sold without incurring high transaction costs or a reduction in price. We generally suggest investors plan to hold their bonds to maturity, at which time the bond will pay back full par value (assuming no default).

Currency risk, also known as exchange rate risk, is present with bonds that are denominated in foreign currencies. Currency fluctuations can impact bond payments when they are converted to U.S. dollars. If a foreign currency weakens after the bond is purchased, the value of the bond and the income payments may decline, negatively impact your return.

There are several ways to purchase bonds outlined below. (Check out our Guide to How to Buy Bonds to find out what to consider before buying a bond.)

You can purchase bonds through from a bank or broker (like Charles Schwab) over the phone or via your online brokerage account. 

If you're buying government bonds, you can purchase them directly from the U.S. Department of the Treasury.

Both mutual funds and ETFs pool money from many investors to purchase a broad range of investments, which include bonds.