What Is a Bond? Fixed Income Basics for Investors

A bond is essentially a loan that you, the investor, make to a borrower — typically a corporation or government. In exchange for lending your money, the borrower promises to pay you regular interest (called the coupon) and return your principal (the face value) at a specific date in the future (the maturity date). Bonds are the foundation of "fixed income" investing — so called because the income stream is fixed at the time of purchase.

How Bonds Work

When you buy a $1,000 bond with a 4% coupon maturing in 10 years, you're lending $1,000 to the issuer. They'll pay you $40 per year in interest ($20 every six months, typically) for 10 years, then return your $1,000 at maturity. If you hold to maturity, you know your exact return from day one — $400 in total interest plus your $1,000 back.

You can also sell a bond before maturity on the secondary market. The price you'll receive depends on current interest rates. If rates have risen since you bought the bond, your below-market coupon rate makes it less attractive — so you'd sell at a discount. If rates have fallen, your above-market coupon is more attractive — you'd sell at a premium.

This inverse relationship — when rates go up, bond prices go down; when rates go down, bond prices go up — is the most important concept in bond investing.

Types of Bonds

Government Bonds

US Treasury bonds are backed by the full faith and credit of the US government — making them the safest bonds available. They come in three maturities: bills (under 1 year), notes (2-10 years), and bonds (20-30 years). Treasury yields serve as the benchmark "risk-free rate" against which all other investments are measured.

Corporate Bonds

Issued by companies to raise capital. Corporate bonds pay higher interest than Treasuries because they carry credit risk — the risk that the company might default on its payments. Investment-grade bonds (rated BBB or higher) have low default risk. High-yield bonds (rated below BBB, also called "junk bonds") offer much higher interest to compensate for elevated default risk.

Municipal Bonds

Issued by state and local governments to fund infrastructure, schools, and public services. Their key advantage: interest income is typically exempt from federal income tax (and often state tax too). This tax exemption makes "munis" especially attractive for investors in high tax brackets.

Key Bond Terms

Yield is the annual return you earn on the bond at its current price (not necessarily its face value). Yield to maturity (YTM) is the total return you'll earn if you hold to maturity, accounting for the purchase price, coupon payments, and return of principal. Duration measures how sensitive a bond's price is to interest rate changes — longer duration means more price volatility.

Credit rating (assigned by agencies like Moody's and S&P) assesses the likelihood that the issuer will default. Higher ratings mean lower default risk but lower yields. Lower ratings mean higher yields but more risk that you won't get your money back.

Bonds vs. Stocks

Bonds and stocks serve different purposes in a portfolio. Stocks are ownership (unlimited upside, significant volatility). Bonds are loans (limited upside, much less volatility). Stocks have historically returned roughly 10% annually; bonds roughly 4-5%. But bonds provide income stability and downside protection that stocks can't match.

In a portfolio context, bonds reduce volatility and provide stable income. When stocks decline during recessions, high-quality bonds often hold their value or appreciate (as rates fall in response to economic weakness). This negative correlation makes bonds an effective portfolio stabilizer — the reason most financial advisors recommend some bond allocation.

For quality stock investors, bonds are less about return generation and more about portfolio stability and capital preservation. The stock portion of the portfolio — concentrated in wide-moat businesses — handles the growth. The bond portion handles the smoothing.