What Are Bonds?

Bonds are essentially loans that you, the investor, make to a corporation or government entity. When you purchase a bond, you're lending money to the issuer in exchange for regular interest payments and the return on your initial investment (called the principal) at the end of a specified period (the maturity date). Unlike stocks, where owning shares means you have partial ownership in a company, bondholders are creditors, not owners. You don’t get voting rights or a stake in the company—you’re simply lending money and getting paid for it.

Think of bonds like an IOU: the issuer (whether it's the government, a corporation, or a municipality) promises to pay back the loan with interest over time. The reliability of these payments is why bonds are often seen as less risky than stocks. However, like any investment, they come with their own set of risks, which we’ll discuss later.

Why Bonds Are Less Risky Than Stocks

Compared to stocks, bonds are considered less risky. This is because bonds typically offer predictable income in the form of interest payments and have lower price volatility. If you hold a bond to its maturity, you’ll receive all the promised interest payments and your initial investment back—assuming the issuer doesn’t default. Stocks, on the other hand, fluctuate much more and can lose value based on market fluctuations. No matter what happens in the stock market, as long as the bond issuer remains solvent, you'll continue receiving your interest payments. This makes bonds a popular option for investors who are nearing retirement or anyone who just doesn’t like stomaching the ups and downs of the stock market.

Interest and Coupon Rates

The main way bonds generate income for investors is through interest payments, often referred to as coupon payments. When you buy a bond, the issuer promises to pay you interest at a fixed rate, known as the coupon rate, for the length of the bond term. This regular interest income is one of the primary attractions of bonds.

For example, let’s say a company offers a 5-year bond with a $1,000 face value and a 5% coupon rate. As a bondholder, you’ll receive $50 in interest every year for five years. At the end of those five years (the maturity date), the company will repay your original $1,000. The coupon rate is fixed at the time you buy the bond, meaning you’ll know exactly how much you’ll earn each year.

While this example might seem simple, not all bonds are as straightforward. Some bonds come with variable coupon rates that change depending on market conditions. Others may not pay interest at all; instead, the bond might be sold at a discount, meaning the bondholder earns their "interest" when they redeem the bond for a higher amount than what they paid. Rather than put us all to sleep, let’s shelve the deep dive into complex bond structures.

Types of Bonds

Bonds come in different varieties, but the two most common types are government bonds and corporate bonds.

• Government Bonds: These bonds are issued by governments to fund public spending and projects. In the U.S., the most well-known are Treasury Bonds (T-Bonds), which are considered one of the safest investments because they are backed by the U.S. government. Municipal bonds, issued by states or local governments, are also common. Because these issuers are seen as very low risk, the interest rates on government bonds tend to be lower.
• Corporate Bonds: These bonds are issued by companies to raise capital for expansion, operations, or other financial needs. Corporate bonds often offer higher interest rates than government bonds to compensate for the additional risk of default. Not all companies are as financially stable as governments, so investors demand a higher return for taking on that risk.

Generally, the higher the risk of the issuer defaulting, the higher the coupon rate offered. For example, a bond issued by a large, stable company like Apple may have a lower interest rate compared to a bond from a smaller, less established company.

Can Bonds Be Risky?

While bonds are typically less risky than stocks, they aren’t entirely risk-free. Here are some of the main risks to be aware of:

• Interest Rate Risk: When interest rates rise, the value of existing bonds tends to drop. For example, imagine you own a bond with a 3% interest rate, but new bonds are being issued at 5%. If you try to sell your bond before it matures, potential buyers (or investors) would prefer the newer 5% bonds. To make your 3% bond more appealing, you would likely have to sell it for less than you paid for it, meaning you could lose money. However, if you hold the bond until it matures, you won’t be affected by interest rate changes and will receive the full principal back.
• Default Risk: This is the risk that the bond issuer (the entity borrowing your money) won’t be able to pay back the interest or the principal. Government bonds, like U.S. Treasury bonds, are considered very safe with low default risk. But corporate bonds—especially those from smaller or less stable companies—can be riskier. In general, riskier bonds offer higher interest rates to attract investors.
• Inflation Risk: Inflation can eat away at the value of your bond’s returns. For example, let’s say you buy a bond with a 3% fixed interest rate. If inflation rises to 5%, the real value of your 3% return shrinks because the cost of goods and services is rising faster than your bond's interest. Essentially, even though you’re still earning 3%, that money doesn’t go as far when prices are going up. It’s like earning $30 in interest but realizing that $30 no longer buys what it used to due to inflation.

Why Bonds Matter in Your Portfolio

Although bonds don’t have the potential for rapid growth like stocks, they play an important role in a balanced investment strategy. Bonds provide stability, regular income, and help diversify your portfolio. This makes them especially useful for investors nearing retirement or those looking to balance higher-risk investments. Since bond prices tend to be less volatile than stocks, they can help reduce overall risk, particularly during periods of market ups and downs.

Before investing in bonds, it’s a good idea to check the bond issuer's credit rating, the bond’s maturity date, and its interest rate (coupon rate). To maximize diversification and reduce risk, consider mixing bonds with other types of investments, like stocks or ETFs, in your portfolio. This strategy can help you achieve your long-term financial goals while spreading out risk across different asset classes.