What is a Bond and How do they Work? | Vanguard (2024)

Types of bonds

Companies can issue bonds, but most bonds are issued by governments. Because governments are generally stable and can raise taxes if needed to cover debt payments, these bonds are typically higher-quality, although there are exceptions.

U.S. Treasuries

These are considered the safest possible bond investments.

You'll have to pay federal income tax on interest from these bonds, but the interest is generally exempt from state tax. Because they're so safe, yields are generally the lowest available, and payments may not keep pace with inflation. Treasuries are extremely liquid.

Certain types of Treasuries have specific characteristics:

  • Treasury bills have maturities of 1 year or less. Unlike most other bonds, these securities don't pay interest. Instead, they're issued at a "discount"—you pay less than face value when you buy it but get the full face value back when the bond reaches its maturity date.
  • Treasury notes have maturities between 2 years and 10 years.
  • Treasury bonds have maturities of more than 10 years—most commonly, 30 years.
  • Treasury Inflation-Protected Securities (TIPS) have a return that fluctuates with inflation.


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  • Separate Trading of Registered Interest and Principal of Securities (STRIPS) are essentially Treasuries that have had their coupon payments "stripped" away, meaning that the coupon and face value portions of the bond are traded separately.
  • Floating rate notes have a coupon that moves up and down based on the coupon offered by recently auctioned Treasury bills.

Read more about Treasury securities

Government agency bonds

Some agencies of the U.S. government can issue bonds as well—including housing-related agencies like the Government National Mortgage Association (GNMA or Ginnie Mae). Most agency bonds are taxable at the federal and state level.

These bonds are typically high-quality and very liquid, although yields may not keep pace with inflation. Some agency bonds are fully backed by the U.S. government, making them almost as safe as Treasuries.

Because mortgages can be refinanced, bonds that are backed by agencies like GNMA are especially susceptible to changes in interest rates. The families holding these mortgages may refinance (and pay off the original loans) either faster or slower than average depending on which is more advantageous.

If interest rates rise, fewer people will refinance and you (or the fund you're investing in) will have less money coming in that can be reinvested at the higher rate. If interest rates fall, refinancing will accelerate and you'll be forced to reinvest the money at a lower rate.

Read more about agency bonds

Municipal bonds

These bonds (also called "munis" or "muni bonds") are issued by states and other municipalities. They're generally safe because the issuer has the ability to raise money through taxes—but they're not as safe as U.S. government bonds, and it is possible for the issuer to default.

Interest from these bonds is free from federal income tax, as well as state tax in the state in which it's issued. Because of the favorable tax treatment, yields are generally lower than those of bonds that are federally taxable.

Read more about municipal bonds

Corporate bonds

These bonds are issued by companies, and their credit risk ranges over the whole spectrum. Interest from these bonds is taxable at both the federal and state levels. Because these bonds aren't quite as safe as government bonds, their yields are generally higher.

High-yield bonds ("junk bonds") are a type of corporate bond with low credit ratings.

Read more about corporate bonds

Inflation

A general rise in the prices of goods and services.

Liquidity

A measure of how quickly and easily an investment can be sold at a fair price and converted to cash.

What is a Bond and How do they Work? | Vanguard (2024)

FAQs

What is a Bond and How do they Work? | Vanguard? ›

By buying a bond, you're giving the issuer a loan, and they agree to pay you back the face value of the loan on a specific date, and to pay you periodic interest payments along the way, usually twice a year. Unlike stocks, bonds issued by companies give you no ownership rights.

How exactly does a bond work? ›

An investor who buys a government bond is lending the government money. If an investor buys a corporate bond, the investor is lending the corporation money. Like a loan, a bond pays interest periodically and repays the principal at a stated time, known as maturity.

How do bonds work for beginners? ›

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.

What is a bond in simple terms? ›

A bond is simply a loan taken out by a company. Instead of going to a bank, the company gets the money from investors who buy its bonds. In exchange for the capital, the company pays an interest coupon, which is the annual interest rate paid on a bond expressed as a percentage of the face value.

How do you make money from a bond? ›

There are two ways to make money on bonds: through interest payments and selling a bond for more than you paid. With most bonds, you'll get regular interest payments while you hold the bond. Most bonds have a fixed interest rate. Or, a fee you get to lend it.…

Is a bond a one time payment? ›

Surety bonds ensure a commitment by the principal, and loss is not expected. Insurance guarantees a coverage of losses and is meant to protect the consumer buying the policy. Surety bonds require a one-time payment.

Are bonds a good investment? ›

There are several benefits that come along with adding bonds to your investment portfolio, and experts suggest that they can help offset some of the risks taken on by more volatile investments. Pro: Bonds can serve as a source of income. Regular interest payments can be a huge selling point for many investors.

Why do people buy bonds? ›

Investors buy bonds because: They provide a predictable income stream. Typically, bonds pay interest on a regular schedule, such as every six months. If the bonds are held to maturity, bondholders get back the entire principal, so bonds are a way to preserve capital while investing.

How do I buy bonds? ›

Many types of bonds can be bought from a bond broker through full-service or discount brokerage channels. This is similar to the way stocks are purchased from a stockbroker. You can also buy bonds as part of an ETF (exchange-traded fund) or mutual fund.

Should you buy bonds when interest rates are high? ›

Should I only buy bonds when interest rates are high? There are advantages to purchasing bonds after interest rates have risen. Along with generating a larger income stream, such bonds may be subject to less interest rate risk, as there may be a reduced chance of rates moving significantly higher from current levels.

What is the safest bond to invest in? ›

Treasuries are generally considered"risk-free" since the federal government guarantees them and has never (yet) defaulted. These government bonds are often best for investors seeking a safe haven for their money, particularly during volatile market periods. They offer high liquidity due to an active secondary market.

Do bonds pay interest monthly? ›

How often do the bonds for sale today earn interest? Both EE and I savings bonds earn interest monthly. Interest is compounded semiannually, meaning that every 6 months we apply the bond's interest rate to a new principal value.

How much money can you put in a bond? ›

Is there a maximum amount I can buy? In a calendar year, one Social Security Number or one Employer Identification Number may buy: up to $10,000 in electronic I bonds, and. up to $5,000 in paper I bonds (with your tax refund)

What is the semiannual interest payment on a $1000 bond with a 7% coupon rate? ›

For example, a $1,000 bond with a coupon of 7% pays $70 a year. Typically these interest payments will be semiannual, meaning the investor will receive $35 twice a year.

How does bond work in US for jail? ›

Bail is the money a defendant must pay in order to get out of jail. A bond is posted on a defendant's behalf, usually by a bail bond company, to secure his or her release. Defendants with pending warrants are usually not eligible for bail.

Who gets the money from a bond? ›

In return for buying the bonds, the investor – or bondholder– receives periodic interest payments known as coupons. The coupon payments, which may be made quarterly, twice yearly or annually, are expected to provide regular, predictable income to the investor..

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