How Do Bonds Work? Coupons for the Investor Set

Bonds are typically considered a more conservative investment that can help diversify your portfolio and help you attempt to ride out stock market volatility. clipping: Intro to bonds, how they work, and how they can help diversify a stock portfolio
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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 bonds work, and what role can they play in your portfolio?

Bonds, a type of fixed-income securities, may play a role in the balancing of an investment portfolio. They can also deliver a reliable 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 markets tend to offer, no matter which direction they 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.

Invest as a Lender, Not an Owner

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 back. A coupon bond, in simplistic terms, is a bond that pays a set rate of interest, known as the coupon rate, on an annual basis to the holder. In years past, bond holders 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—those are the coupon rates—and principal at maturity directly into your account. Paper bonds no longer exist today; it’s all done electronically.

Common bonds types explained

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 is a secondary market for bonds if you would 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. 

How can bonds generate income?

Bonds can generate income in two ways:

  • Interest income. Income can be generated from the set coupon rates; bonds typically pay interest twice a year.  
  • Potential 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. 

  • AAA (or Aaa, depending on the issuing agency) are the highest-quality, investment-grade bonds and are considered the least likely to default. U.S. Treasury bonds are  typically considered the safest by some investors. AA (or Aa) to A are still considered investment-grade ratings that are of high quality or strong. Basically, if a bond’s rating begins with a capital “A," it’s considered a high-quality, investment-grade bond.
  • BBB (or Baa, depending on the rating agency) 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) 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 or C ratings indicate bonds that are already in default.

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. For more on how bonds work, watch the video below.

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.

Investing Basics: Bonds

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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