Bond Investing Basics

Bonds are loans made by investors to governments, companies or other entities. When you buy a bond, you are lending money in exchange for regular interest payments and the promise of getting your principal back at a specified maturity date.

Many investors use bonds to balance the ups and downs of stocks, generate income, or match future liabilities such as tuition or retirement spending. This guide covers the essentials: how bonds are structured, how yields work, the major types of bonds, the key risks to understand, and how to decide where bonds might fit in your overall investing plan.

How a bond works, step by step

A traditional “plain vanilla” bond is straightforward once you break it into parts. Most bonds share a few key features:

• Face value (par): the amount that will be repaid at maturity, often $1,000 per bond.
• Coupon rate: the stated interest rate paid on the face value (for example, 4% per year).
• Coupon payments: the schedule of payments, often semi-annual (twice per year).
• Maturity date: when the issuer is scheduled to repay the face value to investors.
• Issuer: the government, company or agency that promises to make payments.

Imagine you buy a 10-year bond with a face value of $1,000 and a 4% coupon rate. In most cases, you will:

• Pay around $1,000 up front when the bond is issued (the exact price may be slightly above or below par).
• Receive $40 in interest each year (4% of $1,000), usually split into two $20 payments.
• Get your $1,000 back at maturity, assuming the issuer does not default.

After a bond is issued, it can trade in the secondary market. Its price will move up and down as interest rates, credit conditions and investor demand change. This is why bond investors watch both price and yield.

Bond yield and price: the see-saw relationship

One of the most important ideas in bond investing is the relationship between price and yield. When market interest rates rise, existing bond prices generally fall. When rates fall, existing bond prices tend to rise.

Imagine a bond with a 3% coupon issued when market rates are also around 3%. If new bonds later start offering 5%, investors will not pay full price for the older 3% bond. Its price must drop until its effective yield is competitive with new issues. The opposite happens if rates fall below the bond’s coupon.

Coupon, current yield and yield to maturity

Bond investors pay attention to more than just the coupon printed on the bond:

• Coupon rate: the fixed percentage of face value paid each year in interest (for example, 4% of $1,000).
• Current yield: the annual coupon payment divided by the bond’s current market price. If a $1,000 face-value bond with a $40 coupon trades for $950, the current yield is about 4.2%.
• Yield to maturity (YTM): a more complete measure that combines the coupon, the price you pay, and the time left until maturity. It assumes you hold the bond to maturity and reinvest coupons at the same rate.

As a basic rule of thumb, when bonds trade below par (at a discount), their yield to maturity is higher than the coupon. When they trade above par (at a premium), their yield to maturity is lower than the coupon.

Main types of bonds

There are many different bonds, but several broad categories are especially common for individual investors:

Government bonds

Government bonds are issued by national governments. In many developed countries they are considered low credit risk when issued in the local currency. Examples include U.S. Treasuries or Canadian government bonds. Yields tend to be lower than riskier bonds, but they provide a foundation of stability in many portfolios.

Investment-grade corporate bonds

Investment-grade corporate bonds are issued by financially strong companies with higher credit ratings. They typically pay more interest than government bonds to compensate investors for extra credit risk. Investors often use investment-grade bonds for a mix of income and moderate risk.

High-yield (junk) bonds

High-yield bonds are issued by companies with weaker credit ratings. They offer higher yields but come with a greater risk of default. High-yield bond investing is more cyclical, tends to behave more like equities in down markets, and is usually best approached through diversified funds rather than individual issues.

Municipal or provincial bonds

Municipal, provincial or local-government bonds are issued by cities, regions or public agencies. In some countries they can carry tax advantages for local investors. Investors often look at municipal bonds to fund public infrastructure, schools or utilities while receiving interest income.

Inflation-linked bonds

Inflation-linked bonds, such as TIPS in the U.S., are designed to protect purchasing power. Payments adjust with an inflation index, so if inflation rises, the principal and interest payments typically rise as well. These bonds can play a role for investors who are particularly concerned about long-term inflation.

Key risks in bond investing

Bonds are often described as “safer” than stocks, but that does not mean they are risk-free. Major risks include:

• Interest-rate risk: the risk that rising rates will reduce the market value of existing bonds. Longer-maturity and higher-duration bonds are especially sensitive.
• Credit risk: the risk that the issuer will miss payments or default. Lower-rated bonds compensate investors with higher yields but can be volatile in downturns.
• Reinvestment risk: the risk that coupons will be reinvested at lower rates than the original bond, especially in a falling-rate environment.
• Inflation risk: the risk that inflation will erode the real value of future interest and principal payments.
• Liquidity risk: some individual bonds trade infrequently, which can make it harder to sell quickly at a fair price.

Duration: measuring interest-rate sensitivity

One common metric used to estimate interest-rate risk is duration. In simple terms, duration estimates how much a bond or bond fund’s price might move for a 1% change in interest rates.

For example, if a bond fund has a duration of 6, a 1% rise in interest rates is associated with roughly a 6% drop in price (and a 1% fall in rates with roughly a 6% rise in price, all else equal). Short-term bond funds have lower duration; long-term bond funds have higher duration.

Individual bonds vs. bond funds and ETFs

Investors can hold bonds in two main ways:

• Individual bonds: buying specific issues and holding them to maturity. This offers control over cash flows and maturities, but requires more research and larger amounts of capital to diversify.
• Bond mutual funds or bond ETFs: funds that hold many bonds and trade like other pooled investments. These provide diversification and professional management, but their prices fluctuate with the market and there is no fixed maturity date for the fund.

Many investors use bond funds or bond ETFs inside retirement accounts or broad asset-allocation strategies, while others prefer a ladder of individual bonds that mature at different times. Fees, trading costs, and the minimum size of each position are important when choosing between individual bonds and funds.

What is a bond ladder?

A bond ladder is a series of individual bonds that mature at staggered dates (for example, 1-year, 3-year, 5-year, 7-year and 10-year bonds). As each bond matures, you can reinvest the proceeds at current rates or use the cash for spending needs.

Ladders can help reduce reinvestment risk and interest-rate timing risk because you are not forced to reinvest everything at once. They can also make it easier to match future goals such as tuition payments or known retirement expenses.

Where bonds fit in a portfolio

In a mixed portfolio of stocks and bonds, the bond allocation is often used to:

• Reduce overall volatility and smooth out stock-market swings.
• Provide a stream of interest income.
• Create “dry powder” that can be reallocated during market downturns.
• Match known future spending needs such as tuition or retirement withdrawals.

Younger investors with a long time horizon may hold a smaller percentage in bonds, focusing more on growth assets such as stocks. Those closer to retirement often increase their bond allocation to reduce the impact of stock-market swings and create more predictable cash flows.

For a broader view of how bonds interact with other investments, you may also want to read about mutual funds, options, futures and retirement planning.

How to start investing in bonds

If you are a beginner bond investor, a simple way to start is to:

1. Clarify your goal: Are you seeking income, stability, or a specific goal in a certain year (for example, retirement in 15 years)?
2. Choose your vehicle: For most individuals, a low-cost bond ETF or diversified bond mutual fund is simpler than picking individual bonds.
3. Check fees and duration: Compare expense ratios, credit quality and duration across funds. Make sure they align with your risk tolerance and time horizon.
4. Fit bonds into your overall allocation: Decide what percentage of your portfolio should be in bonds versus stocks and other assets, based on your age, goals and ability to handle volatility.

Tip: to understand terms like duration, credit rating and yield spread, you can visit our Dictionary Index for quick definitions.

Questions to ask before buying bonds or bond funds

• What is the credit quality of the issuer or the average rating in the fund?
• What is the duration (a measure of interest-rate sensitivity)?
• How does the yield compare to similar alternatives after fees and taxes?
• Are there any embedded options, such as the issuer’s right to call the bond early?
• What fees apply if I use a bond fund or bond ETF instead of individual bonds?
• How will this investment behave if interest rates rise or fall by 1–2%?

Bond investing FAQ

To see how bonds interact with other investments, you may also want to read about day trading, forex and hedge funds as part of a complete view of markets.