What is a bond? How to earn a steady stream of income by loaning money to a business or government

• A bond is a loan you make to a company or government in exchange for a steady stream of income over a fixed period of time.
• Bonds and bond funds allow individuals to diversify their portfolios while mitigating investment risk.
• Unlike stocks, bonds typically offer lower returns and don't come along with ownership rights or the chance to "win big."

Although stocks tend to garner most of the excitement behind everyday investing, bonds are another major asset class that offer a valuable way to diversify your portfolio.

Bonds are fixed-income securities that represent the ownership of debt and act as loans between a company or government and an investor. They're safer and less volatile than stocks, offering predictable, but often lower returns.

How do bonds work?

A bond is a loan from a lender - like you, the investor - to an issuer, like a company or government. In return, the issuer agrees to pay the principal of the loan, plus interest, by the end of a fixed period of time.

Example: Let's say you buy a 10-year bond from company XYZ with a face value of $1,000 and 5% annual interest. In exchange for the loan, company XYZ promises to pay you $50 each year over the decade. After 10 years, the company pays you back the original $1,000 in full.

Unlike stocks, which represent equity in a company, bonds represent the ownership of debt. In the instance that a company goes bankrupt and investors are paid back, debtholders are prioritized before shareholders, making bonds a safer investment than stocks.

Bonds are issued by governments in need of financing for day-to-day operations, and businesses looking to grow and develop their businesses but lacking the funds necessary for equipment, research, payroll, and more.

Important bond terms to know

• Coupon: The annual interest rate on a bond that is paid to investors in exchange for their loans.
• Face value: How much the bond will be worth at maturity, or when the investment fully matures. It is also called "par" or "nominal" value.
• Yield: The bond yield is a measurement that shows the return you can get on a bond. The simplest way to calculate a bond yield is to divide the bond's coupon by its current price.
• Maturity date: The time by which funds must be repaid to the investor. It is the target date for which the borrower must pay back the loan in full.
• Rating: Rating agencies assign ratings to bond issuers based on their creditworthiness. These ratings can help you understand the risk. "Investment-grade" bonds, or bonds that hold a low risk of default, have a rating of Baa, BBB, or above.

A bond's term to maturity is the length of time a bondholder receives interest payments and correlates with an investor's risk appetite. Usually the longer the bond's term to maturity, the less volatile its price will be on the secondary market and the higher its interest rate.

Bonds are grouped into three main categories, based on how soon they repay investors:

• Short-term bonds: One to five years
• Intermediate-term bonds: five to 12 years
• Long-term bonds: 12 to 30 years

The duration of the bond measures both how long it will take an investor to be repaid the bond's price and how price-sensitive the bond is in response to changing interest rates.

"One of the disadvantages of bonds is that they are very affected by interest rates, so if you buy a long-term bond, you're going to be more subject to prices going up and down based on interest rates," says CFP Luis Rosa.

Higher durations usually mean the bond price is more likely to drop as interest rates rise, which indicates higher interest rate risk. A bond with a three-year duration, for example, will drop 3% as a result of a 1% increase in interest rates, since bond prices typically change about 1% opposite to interest rates for every year of duration.

Types of bonds

Bonds can come from many different kinds of issuers. Generally speaking, there are four main categories of bonds:

• Corporate bonds are issued by companies looking to grow, and appeal to businesses because they often offer lower interest rates than banks.
• Municipal bonds are issued by states and municipalities to finance everyday operations and projects like schools, highways or sewer systems.
• Government bonds are issued by the US Treasury on behalf of the government, and are also referred to as sovereign debt. They're typically used to finance new projects or government infrastructure.
• Agency bonds are issued by government-affiliated organizations and typically pay slightly higher interest rates than US Treasury bonds.

Rosa advises investors to consider their risk tolerance when deciding which type of bond is right for them.

"If you are risk averse, you might want to invest in something a bit more secure, like US treasuries that are backed by the federal government, and if you're in a higher tax bracket, you might want to consider municipal bonds, where you can get some tax-free income," says Rosa.

Bond credit ratings

In the same way that credit scores indicate an individual's creditworthiness, bonds are evaluated by agencies to assess the issuer's ability to make interest payments consistently and repay the loan by its agreed-upon maturity date.

Ratings are based on the issuer's financial health, and bonds with lower ratings are known to offer higher yields to investors, to make up for the additional risk they're taking on.

The three main bond-rating agencies are Moody's, Standard & Poor's (S&P), and Fitch. Higher-rated bonds, also known as investment-grade bonds, hold a rating of "BBB" or above. This means the bond is viewed as less risky because the issuer is more likely to pay off the debt. The tradeoff, however, is often a lower yield.

S&P, Fitch, and Moody's investment-grade ratings

Bonds rated "BB" and below are considered "speculative," or "junk bonds." These issuers typically offer higher yield to offset the risk. It's worth noting that ratings are not set in stone. Agencies can update their ratings, and whether it's an upgrade or a downgrade can affect the bond's price.

S&P, Fitch, and Moody's non-investment-grade ratings

Advantages of bonds

Bonds are typically less volatile than stocks, because investing in debt gives you priority over shareholders in the case of bankruptcy. While a typical retail investor stands the chance of losing everything if a company goes down, debtholders may still get a portion of their money back. On top of that, bonds tend to perform well when stocks aren't, since when interest rates fall, bond prices increase.

Bonds also offer the promise of regular, predictable returns. This sense of certainty can be especially advantageous during some stages of the economic cycle, like a bear market, so bonds balance out periods of decline that affect other investments.

The interest rates on bonds tend to be higher than the deposit rates offered by banks on savings accounts or CDs. Because of this, for longer-term investments, like college savings, bonds tend to offer a higher return with little risk.

Investors should consider both interest rates and time horizon when deciding whether to invest in stocks or bonds.

Disadvantages of bonds

Bonds' predictable returns can be a double-edged sword; although creditors are guaranteed regular payments, there's no chance to "win big" as you might with stocks.

Unlike stocks, bonds do not offer investors any ownership rights. They simply represent a loan between the buyer and the issuer, meaning you won't have a say in where exactly your money goes.

As previously mentioned, the inverse relationship between bond price and interest rates can also be considered a disadvantage, since market volatility means ever-fluctuating bond prices.

Things to know before you invest

There's a lot to consider when deciding whether to invest in a bond versus another financial investment. Here are a few things to keep in mind:

• Timing is key. Because bond values fall when interest rates rise, if you're thinking about selling a bond, timing can make a big difference in your payout. If you sell a bond when interest rates are lower than when you first bought it, you might make a profit. On the flip side, if you sell when interest rates are higher than at the time of your purchase, you'll likely incur some loss.
• The bond issuer's creditworthiness influences its interest rate. As previously mentioned, bond ratings agencies account for the likelihood an issuer will default on payments, and different types of bonds are generally associated with varying levels of risk. US government bonds are among the safest investments, followed by state and local government bonds, and then corporate bonds. Less reliable issuers, like a new company without much of a track record, may issue higher interest rates to compensate for their risk of default.
• Bonds are susceptible to inflation risk. Although bonds are often considered a safe, reliable investment, they're still subject to inflation risk, since they typically pay fixed interest rates despite changing consumer prices.

Consider embedded options

Embedded options give either the holder or issuer of a security certain rights that can be applied later on in the transaction's life, like selling or calling back a bond before its maturity date. These options can be tied to any financial security, but are most often attached to bonds.

Here are a few embedded options that relate to bonds:

• Callable bonds can be "called" back by the company before their maturity dates, and then reissued later on at a lower coupon rate. These are riskier for buyers, since bond issuers are more likely to call back a bond when it's rising in value.
• Puttable bonds work the opposite way, allowing creditors to sell the bond back to its issuer before it's reached maturity. This makes sense when investors expect an increase in interest rates and want their principal back before the bond's value declines. These usually trade for more than non-puttable bonds.
• Zero coupon bonds do not pay coupon payments and instead are issued at a discount to their face value that will generate a return once the bondholder is paid the full face value when the bond matures. US Treasury bills are a zero-coupon bond.
• Convertible bonds uniquely allow bondholders to convert their bonds into stock if they expect the stock's share price to eventually rise above a certain value.

Another available option when it comes to buying bonds is investing in bond funds rather than individual bonds.

"They trade every day, so you don't have to wait until maturity if, for some reason, you do need your money," says Rosa, adding that they're professionally managed and offer more diversification than a single bond.

The financial takeaway

Bonds are a unique asset class that represent the ownership of debt in a business or government entity. They're safer and less volatile than stocks, and offer the promise of regular, predictable returns.

Despite their benefits, bonds also tend to offer lower returns than stocks and don't come along with any ownership rights. Be sure to assess your time horizon and risk tolerance when deciding whether to invest in this asset.

Bonds vs. CDs: The key differences and how to decide which income-producing option is better for youBonds can be taxable or tax-free - here's your guide to the different types and calculating what's due on themHow to buy treasury bonds, one of the safest ways to invest for incomeHow many stocks should you own in your portfolio? Why there's no single 'right' answer