When you buy a bond, you’re essentially lending money to a corporation or government.
Bonds may offer an investor a steady income stream in the form of interest payments.
Bonds are generally considered less risky than many other asset classes, which may help stabilize a portfolio.
Corporations and governments borrow money for all kinds of reasons. When they do, they often sell bonds to raise the money they need — and investors can buy those bonds for their financial portfolios. Investment in bonds can be a good way to diversify a portfolio, balance risk, and likely earn a steady income. What is a bond? What types of bonds are out there? And what possible benefits do bonds offer?
A bond is an investment that represents a loan to a corporation or government and generates interest payments for its owner. At the end of a set time period, the principal is refunded.
Here's a hypothetical example. Suppose a company is raising money to build a new factory. It’s offering bonds with a $1,000 face value and a coupon rate (interest rate) of 5% that matures in five years. An investor who purchases and holds the bond will receive $50 each year for five years. After five years, the investor receives back their initial $1,000 investment. They will have earned $250 in interest.
Bonds can be categorized in multiple ways, depending on:
Companies may issue corporate bonds to raise money for various needs, like expanding their business or paying off other debts. Both US and global companies issue corporate bonds.
In the US, state and local governments may issue municipal bonds (munis) to fund public projects such as schools, highways, and water systems. Interest from municipal bonds is often exempt from federal income taxes and possibly state and local taxes as well. Some munis are backed by the full faith and credit of the issuing government, while others are tied to tolls, utility fees, or some other specific revenue source.
The US government sometimes issues bonds to pay for infrastructure, social programs, military operations, and more. Treasury bonds, notes, and bills are backed by the full faith and credit of the US government. Their income is generally subject to federal income tax but exempt from state and local taxes.
International governments also issue bonds, such as gilts in the UK, bunds in Germany, Japanese government bonds, and Government of Canada bonds.
Organizations affiliated with the government or agencies of the government may issue agency bonds to support their sector of the economy. Bonds from government-sponsored enterprises like Fannie Mae are not directly backed by the government, while bonds from government agencies like the Government National Mortgage Association (Ginnie Mae) are guaranteed by the government.
Bonds are rated for their risk level on a scale from D (lowest) to AAA (highest). That risk is determined by credit ratings agencies, such as Moody’s, Standard & Poor’s, and Fitch, which assess the creditworthiness of the entities issuing the debt. Bonds generally fall into one of two categories: investment grade and high yield.
Investment grade bonds generally range from BBB- to AAA. Some corporate, municipal, government, and agency bonds may be considered investment grade, which means their risk of default is low. Entities issuing these bonds — established corporations and governments — have a lower risk of default.
High yield bonds are rated below BBB-, and this designation can apply to corporate, municipal, government, and agency bonds. Entities issuing bonds in this category have a higher risk of default. In exchange for taking on more risk, these bonds pay investors higher yields than investment grade bonds.
The yield payments for bonds can be structured in many ways depending on market conditions, investor preferences, and issuer goals. Fixed rate and floating rate are the two most common approaches.
A fixed rate bond is essentially a loan to the issuer in exchange for regular interest payments. The amount of these coupon payments remains the same for the life of the bond, after which the principal is returned. Fixed rate bonds may pay a reliable income, but those payments will lose purchasing power with inflation.
A floating rate bond is also a loan to the issuer in exchange for regular interest payments. However, the interest rate may change periodically based on a benchmark interest rate such as the Secured Overnight Financing Rate. Floating rate bonds adjust with the market, acting as a hedge against rising interest rates. But this variability makes income less predictable.
Fixed rate bonds may offer an investor a steady income stream in the form of interest payments. Fixed payments are contractually obligated and typically made annually or semi-annually, providing a predictable and reliable source of income. Regularity can help you plan your finances and create peace of mind in uncertain times.
A bond investor is promised the return of their investment in full upon maturity. The value of that investment doesn’t fluctuate as an investment in stocks might. This feature offers a level of security that can be reassuring, particularly if the money is earmarked for a certain purpose down the road.
Bonds are generally considered safer than many other asset classes, and their lower risk can help stabilize an investment portfolio. Offsetting exposure with bonds may provide a buffer against a volatile stock market. When stock values fluctuate, bonds may still deliver a steady return. They may also be an effective hedge against more specific risks, such as interest rate changes.
When interest rates rise, new bonds are issued with higher coupons. Older bonds with lower coupons become less attractive, and their prices generally fall. Selling an older bond before it matures can lead to a loss of principal if buyers can find a higher-paying bond elsewhere.
Bonds come with the possibility that the issuer fails to make interest payments or pay back the principal. This credit risk (or default risk) is generally higher for corporate bonds than for government bonds and rises for bonds from companies with lower credit ratings. Agencies like Moody’s, Standard & Poor’s, and Fitch rate the creditworthiness of entities issuing debt.
Returns from bonds may not keep pace with inflation. The risk is that inflation can erode the real value of fixed interest payments and principal over time leading to less purchasing power. Long-term bonds are particularly susceptible.
A bondholder may not wish to hold a bond until its term ends, creating the possibility that an investor can’t sell it quickly or at a fair price. This liquidity risk is lower for government bonds and highly rated corporate bonds, which have active secondary markets. However, it’s higher for lower-rated and less commonly traded bonds.
A bond issuer may decide to repay the principal ahead of a bond’s maturity date. A fall in interest rates is one possible reason for a bond to be called. An investor may then be unable to reinvest the principal for the same coupon, reducing their expected income.
Fluctuations in foreign exchange rates can impact investors of international bonds.
A bond’s benchmark rate is the interest rate that determines its variable interest payments. It adjusts periodically so that the bond’s yield reflects current market conditions and protects investors against interest rate changes.
A bond’s coupon is the interest payment received from the investment expressed as a percentage of the bond’s face value. These payments tend to be fixed amounts issued annually or semi-annually.
A bond’s duration measures its sensitivity to interest rate changes. A longer duration suggests more price volatility when interest rates change.
A bond’s face value (or par value) is the amount it will be worth at maturity and the amount the issuer pays back. It tends to be fixed at $1000.
A bond’s maturity date is when the issuer will return the face value to the investor. Maturities can be short-term (less than 3 years), medium-term (3-10 years), or long-term (more than 10 years).
A bond’s price is how much it costs on the open market. It can move up and down according to interest rates, the company’s credit rating, and market demand.
A spread is the fixed percentage added to the benchmark to determine the total interest rate, or coupon, of a floating rate bond. It’s payment for the additional credit risk an investor takes on when buying a bond from that issuer.
A bond’s yield is the overall return on the investment and can vary based on the current market price. If the price goes up, the yield goes down. If the price goes down, the yield goes up.
Bonds aren’t just for conservative investors. They can help diversify a portfolio to balance out risk and earn a steady income. The potentially reliable benefits of fixed income matter more in an uncertain market. With economic turbulence set to continue, bonds offer investors growth and a little peace of mind.
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Diversification does not guarantee a profit or eliminate the risk of loss.
Fixed-income investments are subject to credit risk of the issuer and the effects of changing interest rates. Interest rate risk refers to the risk that bond prices generally fall as interest rates rise and vice versa. An issuer may be unable to meet interest and/or principal payments, thereby causing its instruments to decrease in value and lowering the issuer’s credit rating.
Municipal securities are subject to the risk that regulatory or economic factors could affect an issuer's ability to make payments of principal and/ or interest and the fund's ability to sell it. Changes in applicable tax laws or tax treatments or an issuer's failure to comply with tax requirements may adversely affect a municipal security's tax status or make income taxable.
The risks of investing in securities of foreign issuers can include fluctuations in foreign currencies, political and economic instability, and foreign taxation issues.
A credit rating is an assessment provided by a nationally recognized statistical rating organization (NRSRO) of the creditworthiness of an issuer with respect to debt obligations, including specific securities, money market instruments or other debts. Ratings are measured on a scale that generally ranges from AAA (highest) to D (lowest); ratings are subject to change without notice. NR indicates the debtor was not rated and should not be interpreted as indicating low quality. For more information on rating methodologies, please visit the following NRSRO websites: visit www.standardandpoors.com and select 'Understanding Credit Ratings' under 'About Ratings' on the homepage; https://ratings.moodys.io/ratings and select 'Rating Methodologies' on the homepage; visit www.fitchratings.com and select 'Criteria' under 'Resources' on the homepage. Then select 'Rating Definitions' under 'Resources' on the 'Contents' menu.
High yield bonds, or junk bonds, involve a greater risk of default or price changes due to changes in the issuer’s credit quality. The values of junk bonds fluctuate more than those of high-quality bonds and can decline significantly over short time periods.
There is a risk that the value of the collateral required on investments in senior secured floating rate loans and debt securities may not be sufficient to cover the amount owed, may be found invalid, may be used to pay other outstanding obligations of the borrower or may be difficult to liquidate.
Invesco does not provide tax advice. The tax information contained herein is general and is not exhaustive by nature. Federal and state tax laws are complex and constantly changing. You should always consult your own legal or tax professional for information concerning your individual situation. The tax information presented is based on current interpretation of federal income tax law. State and local income tax laws may differ from federal income tax law.
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