How do bonds work?

Without loans, most of us wouldn't be able to afford things like a car, a home or education. And, just as people borrow money to help them succeed, so do businesses. Businesses often need loans to fund operations, move into new markets, innovate and grow in general. But the amount they need often surpasses what a bank can provide. So another useful way for corporations to raise the necessary funds is to issue bonds to whoever wants to buy them.

But that's all a bond is — a loan. When you buy a bond, you're lending money to the organization that issues it. The company, in return, promises to pay interest payments to you for the length of the loan. How much and how often you get paid interest depends on the terms of the bond. The interest rate, also called the coupon, is typically higher with long-term bonds. These interest payments are usually doled out semiannually, but they can also be sent out annually, quarterly or even monthly. When the bond reaches the date of maturity, the issuer repays the principal, or original amount of the loan.

For you, the lender, a bond is a kind of investment, like a stock. The difference is that stocks aren't loans. Rather, stocks represent partial ownership in a company, and the returns represent a share in profits. For that reason, stocks are riskier and more volatile — they closely reflect the success of a company. Bonds, on the other hand, often have a fixed interest rate. Some bonds, however, are floating-rate bonds, meaning their interest rates adjust depending on market conditions.

Like stocks, bonds can be traded. When someone sells a bond at a price lower than the face value, it's said to be selling at a discount. If sold at a price higher than the face value, it's selling at a premium.

Now that we know the basics, let's take a look at the different types of bonds.

Types of Bonds

Businesses aren't the only entities that can issue bonds. Governments and municipalities sell them as well. Let's look at how these kinds of bonds differ.

Government Bonds: To fund programs, meet their payrolls and essentially pay their bills, governments issue bonds. Bonds from stable governments, such as the United States, are considered extremely safe investments. Bonds from developing countries, on the other hand, are more risky. The U.S. government issues its own bonds from the treasury and from several government agencies. Those maturing in less than one year are known as T-bills. Bonds that mature in one to 10 years are T-notes, and those that take more than 10 years to mature are treasury bonds. In some cases, you don't have to pay state or local income taxes on the interest they earn.

Municipal Bonds: Municipal bonds — also called "munis" — are issued by states, cities, counties and various districts to raise money to finance operations or to pay for projects. Munis finance things like hospitals, schools, power plants, streets, office buildings, airports, bridges and the like. Municipalities usually issue bonds when they need more money than they collect through taxes. The good thing about municipal bonds is that you don't have to pay federal income taxes on the interest they earn.

Corporate Bonds: Corporate bonds are issued by businesses to help them pay expenses. While corporate bonds are a higher risk than government bonds, they can earn a lot more money. There's also a much larger selection of corporate bonds. The disadvantage is that you do have to pay federal income tax on the interest they earn.

Especially when investing in corporate bonds, it's important to consider how risky the bond is. No investor wants to pour a lot of money into a low-yield bond if there's a 50-50 chance the company will go under. You can research the issuer's financial situation to see how solid its prospects are. This involves investigating things like cash flow, debt, liquidity and the company's business plan.

As fun as it sounds to research these things, most of us don't have the time or skills to analyze a corporation's financial situation accurately. Thankfully, there are organizations that do this work for us, like Moody's Investors Service and Standard & Poor's. Their experts research a company's situation and determine a bond rating for the company.

Every rating service has its own formula for measuring risk and its own kind of rating scale. Typically, rating scales are spelled out in letter grades, where an AAA rating designates a safe, low-risk bond, and a D rating designates a high-risk bond. Safer bonds, like U.S. government bonds, are usually low-yield bonds. You can depend on getting a payout — but that payout will be small.

On the other side of the spectrum, you have what's not-so-affectionately known as junk bonds, which are low-rated, high-risk bonds. In order to entice investors into buying these risky junk bonds, the issuing companies promise high yields. If you buy a junk bond, there's no guarantee you'll ever see your money again. But if you do, you could get paid in spades.

Still unsure about some of the terms related to bond investment? Check out the glossary on the next page.

Bond Terminology

Bonds may have characteristics that are good for the buyer (that would be you), the seller or both. Here are some terms you should be familiar with before selecting a bond:

Maturity - Bonds have lifetimes. Depending on the type of bond, that lifetime can last anywhere from one month to 50 years.
Callability - This is a term that means the company or agency that issued the bond has the right to call the bond back in at a time of their choice. In other words, the company buys the bond back before it matures. An agency might do this when interest rates are falling in order to issue new bonds at lower rates so it'll save money. This isn't always a bad deal for those who bought the bonds, either, because there is an extra premium added to the face value of the bond.
Put provision - Just as callability allows the seller to call the bond back before it matures, some (but not too many) bonds have a put provision that gives the person who bought the bond a chance to sell it back at face value before it matures. It can't be done at any time, however; the seller must schedule this ahead of time. People who own bonds sometimes put their bonds when interest rates are rising so they can invest their money where it will earn more.
Convertible bonds - Sometimes bonds can be converted into stock in the company that issued them. At the time the convertible bonds are issued, exactly when and at what price they can be converted to stocks is specified. This type of bond usually offers lower interest rates initially, but it also offers the potential for higher earnings as a stock.
Secured bonds - Bonds that are backed by collateral are called secured bonds. This means that the company or agency that issued the bond also has money or assets to cover the bond's value. Money or the assets would be given to the people who bought the bonds in the event that the company goes bankrupt.
Unsecured bonds - Also called debentures, unsecured bonds are not backed by collateral; they're simply backed by the creditworthiness of the company or agency issuing the bonds. Government bonds are unsecured because the U.S. government is so creditworthy.

Bonds are much more complicated than we've explained here and have a lot more terms to describe their different features. For even more insight into bonds, follow the links on the next page.

How do bonds work?

Types of Bonds

Bond Terminology

Lots More Information

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