How do bonds generate a return? (2024)

FAQs

How do bonds generate returns? ›

How bonds generate income. As we discussed in Topic 1 of this series, governments and corporations issue bonds when they need to raise money. In return for buying the bonds, the investor – or bondholder– receives periodic interest payments known as coupons.

A bond's yield is the return to an investor from the bond's interest, or coupon, payments. It can be calculated as a simple coupon yield or using a more complex method like yield to maturity.

There are two ways to make money by investing in bonds. The first is to hold those bonds until their maturity date and collect interest payments on them. Bond interest is usually paid twice a year. The second way to profit from bonds is to sell them at a price that's higher than you initially paid.

The three sources of return on a fixed-rate bond purchased at par value are: (1) receipt of the promised coupon and principal payments on the scheduled dates, (2) reinvestment of coupon payments, and (3) potential capital gains, as well as losses, on the sale of the bond prior to maturity.

Bonds carry the promise of their issuer to return the face value of the security to the holder at maturity; stocks have no such promise from their issuer. Most bonds pay investors a fixed rate of interest income that is also backed by a promise from the issuer.

The people who purchase a bond receive interest payments during the bond's term (or for as long as they hold the bond) at the bond's stated interest rate. When the bond matures (the term of the bond expires), the company pays back the bondholder the bond's face value.

Bonds are an investment product where you agree to lend your money to a government or company at an agreed interest rate for a certain amount of time. In return, the government or company agrees to pay you interest for a certain amount of time in addition to the original face value of the bond.

You can calculate your total return by adding the interest earned on the bond to the gain or loss your incur. The gain or loss may be generated based on selling the bond, or simply holding the bond until maturity.

Bonds – also known as fixed income instruments – are used by governments or companies to raise money by borrowing from investors. Bonds are typically issued to raise funds for specific projects. In return, the bond issuer promises to pay back the investment, with interest, over a certain period of time.

Bond investments provide steady streams of income from interest payments prior to maturity. The interest from municipal bonds generally is exempt from federal income tax and also may be exempt from state and local taxes for residents in the states where the bond is issued. As with any investment, bonds have risks.

Do bonds generate passive income? ›

Passive income is a regular cash flow that doesn't require much time or effort to maintain. Think: selling courses online or renting out a room in your house. You can potentially make passive income through investing in funds or stocks that pay dividends, as well as bonds, bond funds, and real estate.

Simple example

On a $1,000 bond, if the coupon interest rate is 3% and inflation is 1% after six months, the principal is adjusted to $1,010. You then receive a semi-annual interest payment of $15.15. If inflation rises to 3% by year end, the principal is adjusted to $1,030.

With the S&P 500 up by double digits over the past year, it may be tempting for investors to ignore bonds. Compared to the stock market, a 5% yield on a high-quality investment-grade corporate or US Treasury bond is hard to get excited about. And those yields appear to be the good news about bonds.

Essentially, the price of a bond goes up and down depending on the value of the income provided by its coupon payments relative to broader interest rates. If prevailing interest rates increase above the bond's coupon rate, the bond becomes less attractive.

Because bonds typically carry less risk than stocks, these assets can be a good choice for investors with less time to recoup losses. Income generation: Bonds provide a fixed amount of income at regular intervals in the form of coupon payments.

What causes bond prices to fall? Bond prices move in inverse fashion to interest rates, reflecting an important bond investing consideration known as interest rate risk. If bond yields decline, the value of bonds already on the market move higher. If bond yields rise, existing bonds lose value.