A bond is a loan you make to a government or company, and they pay you back with interest

When you buy a bond, you are lending money. The borrower — usually a government or corporation — promises to pay you back the full amount on a specific date, called the maturity date. Until then, they pay you interest, usually twice a year. That interest payment is called the coupon. You get a fixed amount of money at regular intervals, which is why bonds are often called fixed-income investments.

The price you pay for a bond is not always the same as what you get back. If you buy a bond for $1,000 and hold it until maturity, you get $1,000 back. But if you sell it before maturity, the price depends on interest rates and how risky the borrower looks. This is the main reason bond prices move up and down.

Key Takeaways

  • When you buy a bond, you lend money to a government or company and receive regular interest payments until the loan is repaid.
  • The interest rate on a bond is set when you buy it and does not change, even if market rates rise or fall.
  • If you sell a bond before it matures, you may get more or less than you paid, depending on whether interest rates have gone up or down.
  • Government bonds are generally safer than corporate bonds because governments can raise taxes or print money, but they pay lower interest.
  • The longer you wait for your money back, the more interest the bond pays you, because you are taking on more risk.

The difference between government bonds and corporate bonds

Government bonds are issued by federal, state, or local governments. The U.S. Treasury issues bonds at the federal level — these are called Treasury bills (under one year), Treasury notes (two to ten years), and Treasury bonds (over twenty years). States and cities issue municipal bonds to pay for schools, roads, and other projects. Government bonds are considered safer because the government can raise taxes or, in the case of the federal government, print money to pay you back.

Corporate bonds are issued by companies. They pay higher interest than government bonds because companies can go bankrupt and fail to pay you back. The interest rate a company offers depends on how likely it is to repay — a stable utility company pays less interest than a startup with uncertain profits. Credit rating agencies like Moody's and Standard & Poor's assign letter grades (AAA, BBB, C, and so on) to show how risky a bond is.

Most individual investors start with government bonds or bonds from large, stable companies. High-yield bonds, sometimes called junk bonds, pay much higher interest but carry real risk of default — the borrower stops paying you back.

How interest rates affect bond prices

When you buy a bond, the interest rate is locked in. If you bought a bond paying 3 percent and interest rates rise to 5 percent, your bond is now less attractive — new bonds pay more. If you try to sell it, you have to accept a lower price to make up for the lower interest rate. The opposite happens when rates fall: your bond becomes more valuable because it pays more than new bonds.

This is why bond prices and interest rates move in opposite directions. You only experience this price change if you sell before maturity. If you hold the bond until it matures, you get your full principal back regardless of what happened to interest rates in between.

The longer the bond's maturity, the more its price swings when interest rates change. A thirty-year bond's price moves much more than a two-year bond's price when rates shift. This is called duration risk, and it is the main reason longer-term bonds pay higher interest.

What you actually receive as a bond investor

You receive two types of payments. First, you get periodic interest payments — usually every six months — for as long as you hold the bond. Second, when the bond matures, you get back the principal, the original amount you lent. If you sell the bond before maturity, you get whatever price the buyer will pay, which may be more or less than you paid.

If a bond issuer goes bankrupt, you are not completely out of money. Bondholders are paid before stock investors — you are a creditor, not an owner. But you may not get the full amount back. This is why credit ratings matter: they tell you how likely the issuer is to pay in full.

How to buy bonds

You can buy individual bonds directly from the U.S. Treasury through TreasuryDirect.gov at no cost. For other government and corporate bonds, you typically buy through a brokerage account — the same place you would buy stocks. You pay a commission or bid-ask spread, a small markup the broker adds to the price.

Many people buy bonds indirectly through bond funds or bond ETFs (exchange-traded funds). These are pools of many bonds managed by a professional. You own a small piece of the whole pool. Bond funds are easier to buy and sell than individual bonds, and they spread your risk across many issuers. The downside is that bond funds charge an annual fee, usually 0.1 to 1 percent of what you invest, and they do not have a maturity date — the fund exists as long as the company runs it.

The trade-off between safety and interest rate

Safer bonds pay less interest. U.S. Treasury bonds are the safest — the federal government has never defaulted — but they pay the lowest rates. Corporate bonds from stable companies pay more. High-yield bonds pay much more but carry real risk. Your choice depends on how much risk you can afford to take and how long you can wait for your money.

If you need the money in two years, a long-term bond is a poor choice because its price could drop significantly if interest rates rise. If you can wait twenty years, you can afford to buy a longer-term bond and lock in current interest rates. If you cannot afford to lose any money, Treasury bonds are the right choice even though they pay very little.

Frequently Asked Questions

What happens if I need my money before the bond matures?

You can sell the bond on the secondary market, but you may get less than you paid if interest rates have risen. If rates have fallen, you may get more. Individual Treasury bonds are easy to sell. Corporate bonds are harder to sell quickly without accepting a lower price.

Can I lose money on a bond?

Yes, in two ways. If you sell before maturity and interest rates have risen, you get less than you paid. If the issuer defaults, you may not get your full principal back. If you hold until maturity, you get your full principal back unless the issuer defaults.

Why would I buy a bond instead of keeping money in a savings account?

Bonds pay higher interest than most savings accounts, especially longer-term bonds. A savings account is safer and more liquid — you can withdraw anytime — but it pays almost nothing. Bonds are a middle ground: more interest than savings, but more risk and less liquidity than cash.

What is the difference between a bond and a CD?

A CD (certificate of deposit) is issued by a bank and insured by the FDIC up to $250,000. A bond is issued by a government or company and has no insurance. CDs pay less interest but are safer. Bonds pay more but carry credit risk — the issuer might not pay you back.