What Are Bonds and How Do They Work?

Bonds are typically considered a more conservative investment that can help diversify your portfolio and attempt to ride out stock market volatility.

https://tickertapecdn.tdameritrade.com/assets/images/pages/md/A bond with the cover pulled back to reveal the tools of how bonds works
4 min read
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Key Takeaways

  • Types of bonds include Treasuries, municipal bonds, savings bonds, and corporate bonds
  • Learn how interest rate changes affect bond prices and why that might matter to a bond investor
  • Bonds carry an element of risk, so it’s important to understand how bond ratings work

Some investors use bonds when attempting to diversify and balance their portfolios. But what are bonds, how do they work, and what role can they play in your portfolio?

Bonds, a fixed income investment, may play a role in balancing an investment portfolio. They can also deliver a stream of income, particularly in retirement.

Bonds tend to be viewed as a more stable and predictable form of investing compared to the stock market. Bonds may help you ride out the volatility that the stock market tends to offer, no matter which direction it might be headed.

Like stocks, bonds can run in cycles, but they’re typically less volatile. Bonds sometimes outperform stocks when a bear market hits, potentially providing a measure of diversification for investors who are attempting to put together more balanced portfolios. And like stocks, they do carry an element of risk, so investors should carefully research a bond and its risk before investing.

What Are Bonds and How Do Bonds Work?

Bonds are financial instruments issued by states and municipalities, the federal government, or corporations as a tool for raising capital. You, the investor, loan money to the issuer for a set amount of time at a variable or fixed rate. In return, the issuer promises to make periodic payments and, at maturity, to repay your principal. A coupon bond, in simplistic terms, is a bond that pays a set rate of interest, known as the coupon rate, on an annual or semi-annual basis to the holder. In years past, bondholders would receive physical bonds with coupons attached, which they would cut off—hence the old term “clipping a coupon”—and present to a bank for payment.

One exception, though: A type of bond called a “zero-coupon bond” is designed to return the principal at maturity, but with no payments along the way. To compensate the investor, it’s sold at a discount. So, for example, you might buy a $1,000 face value zero-coupon bond for $700, and at maturity, you’ll receive the $1,000 face value.

How Does Bond Issuance Work?

Bonds typically have a face value of $1,000, although a bond’s price may change over its life. When you purchase a bond through a broker such as TD Ameritrade, you become the registered owner of the bond, and the broker will credit interest payments (the coupon rates) and principal at maturity directly into your account. Paper bonds no longer exist today; it’s all done electronically.

What Does “At Maturity” Mean?

All bonds have a set maturity date, which is when the principal amount, or the face value, is scheduled to be paid in full. Bonds generally fall into short-, medium-, and long-term durations, and the time to maturity is usually set when the bond is issued. But if you invest in a long-term bond, that doesn’t mean you have to hold the bond until maturity; there’s a secondary market for bonds if you’d like to sell before maturity. But remember: Bond prices fluctuate as interest rates change. Plus, there’s always a risk of default by the issuer, and that level of risk can rise and fall, so changes in the risk environment can and do affect bond prices.

Bond typeDescriptionFun Fact
Treasury bonds, notes, billsWith Treasuries, you’re essentially loaning money to the U.S. government. Treasuries are backed by the full faith and credit of the United States.Why the different names? It’s all about maturity. If one year or less at issuance, it’s a T-bill. From two to 10 years it’s a T-note, and above 10 years it’s a T-bond.
Savings bonds*
*Savings bonds aren’t available through TD Ameritrade.
Also issued by the U.S. Treasury, a Series EE bond is a perennial favorite as a gift from grandparents. It can be sold in denominations as low as $25.Savings bonds were first authorized in 1935 to “encourage broad public participation in government financing.” During World War II, they became known as War Savings Bonds.
Municipal bonds (“Munis”)Issued by non-federal government entities—states, counties, cities—often for a specific purpose such as the building of bridges, roadways, airports, or schools.  The interest paid by munis is typically exempt from federal income taxes, and sometimes state and local taxes as well
Corporate bondsIssued by a company to fund new projects or for ongoing expenses. Corporate bonds can be short term or long term, and some are riskier than others.Rating agencies such as S&P or Moody’s will assign a rating—essentially a risk assessment—based on the likelihood of a default by the issuer.  

How Can Bonds Impact a Portfolio?

Bonds can have a positive impact on a portfolio in two ways:

  • Income from coupon payments. Income can be generated from the set coupon rates; bonds typically pay interest twice a year.
  • Potential capital gains from a rise in the price of the bond. Bond prices typically move in conjunction with interest rates but in opposite directions. If, for example, you own a bond that pays a 4% coupon, and interest rates drop to 3%, the bond you’re holding rises in value and you can potentially sell your bond in the secondary market at a higher price than your original purchase price.

Of course, if interest rates rise, the bond you’re holding loses value, and could result in a loss if sold before maturity. But it’s important to note that changes in interest rates have no bearing on the interest paid on your bond. Unless the issuer defaults, if you hold it until maturity, you’ll receive all of the coupon payments and your full principal.

How Risky Are Bonds?

Bonds are often viewed as a less risky alternative to stocks, but that doesn’t mean they are risk free. All bonds carry a degree of credit risk that the issuer might default. Ratings agencies evaluate the issuer’s ability to repay the bond and grade them accordingly. There are a number of such agencies, each with its own ratings classification system. Standard & Poor’s, Moody’s, and Fitch Ratings are commonly referred to as the big three.

The actual ratings scale, and the cutoff between investment grade and non-investment grade, can vary slightly among agencies, but in general, the ratings run from the As to Cs and Ds. The higher a bond is in the alphabet, the better.

  • AAA (or Aaa, depending on the issuing agency). These are the highest-quality, investment-grade bonds and are considered the least likely to default. U.S. Treasury bonds are typically considered a high-quality, investment-grade bond. Just below AAA are bonds rated AA and A—still considered high quality but not the absolute tip-top ratings.
  • BBB (or Baa, depending on the rating agency). These bonds are still considered investment grade, but there may be more uncertainty regarding the issuer’s ability to meet long-term financial obligations. Bonds rated BB/B and Ba/B and lower are commonly referred to as “junk bonds” and are considered to be speculative.
  • CCC/CC/C (or Caa/Ca, depending on the rating agency). These carry an even higher risk of default and are considered highly speculative. But these bonds are generally offered with very high interest rates, making them high-yield bonds.
  • D (and those rated “C” by Moody’s). These ratings indicate bonds that are already in default, with little prospect for recovery. 

Bottom Line on How Bonds Work

If you’ve ever heard someone say, “It’s not about the money; it’s the principle,” you know it’s about the money...at least a little bit.

With bonds, it’s about the principal (spelled the other way), as well as the interest. Because in the end, it is about the money. Your money.

Although all investments carry risks, investment-grade bonds can be less risky than stocks and can potentially add a measure of balance and diversification to a portfolio. But like all investments, it’s important to understand what you’re buying—the risks, the potential return, and how prices may fluctuate over the life of the investment.

Investments in fixed income products are subject to liquidity (or market) risk, interest rate risk (bonds ordinarily decline in price when interest rates rise and rise in price when interest rates fall), financial (or credit) risk, inflation (or purchasing power) risk, and special tax liabilities. May be worth less than the original cost upon redemption.

Asset allocation and diversification do not eliminate the risk of experiencing investment losses.


Key Takeaways

  • Types of bonds include Treasuries, municipal bonds, savings bonds, and corporate bonds
  • Learn how interest rate changes affect bond prices and why that might matter to a bond investor
  • Bonds carry an element of risk, so it’s important to understand how bond ratings work

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