Understanding bond definitions and meanings

Bonds are loans made to governments, corporations, and agencies in exchange for regular interest payments and the return of principal at maturity. Understanding how bonds work is essential for anyone looking to invest in fixed-income securities or diversify their portfolio beyond stock trading.

In this guide, we’ll dive into everything you need to know about bonds, including how they work, different types of bonds, the risks and benefits of investing in bonds, and how you can start investing in bonds today.

What is a bond?

Bonds are debt securities that involve an issuer, like a government or corporation, borrowing money from investors. In return, investors receive regular interest (called coupon payments) and are repaid the full amount at a set maturity date.

Basic characteristics of bonds

To understand bonds, it’s important to know their basic characteristics:

• Issuer: The entity borrowing the money, usually a government or corporation
• Face value (par value): The original amount borrowed, typically repaid in full at maturity
• Coupon rate: The fixed interest rate the bond pays, usually expressed as a percentage of the face value
• Maturity date: The date the issuer must repay the face value of the bond
• Coupon payments: Interest payments made to the bondholder, often semi-annually.

How bonds work

Let’s say a government issues a 10-year bond with a face value of $20,000 and a 5% annual interest rate paid semi-annually. The bondholder receives $500 every six months (totaling $1,000 per year) in interest, and at the end of 10 years they get back their original $20,000.

It’s important to note that, while a bond’s face value stays fixed, its price in the market can fluctuate based on interest rates. If interest rates rise, bond prices generally fall, and vice versa. This matters if the bond is sold before maturity.

Bond are often categorised by their term:

• Short-term: Less than 4 years
• Intermediate-term: 4 to 10 years
• Long-term: More than 10 years.

Types of bonds

There are several types of bonds, which we briefly explain below.

Treasury bonds (U.S. Treasuries)

Treasury bonds are issued by the U.S. Department of the Treasury. Their very low risk of default makes them some of the safest investments available. There are three types of U.S. Treasuries:

• Treasury Bills (T-Bills): T-Bills mature in 52 weeks or less and don’t pay interest. Instead, they’re sold for less than their face value but pay back the full face value at maturity.
• Treasury Notes (T-Notes): T-Notes pay interest every six months and are issued in maturities of 2, 3, 5, 7, or 10 years.
• Treasury Bonds (T-Bonds): T-Bonds are long-term bonds with 20 or 30 year maturities that pay interest every six months.

Money raised from selling Treasuries is used to fund various government activities. Because of their low risk, U.S. Treasuries have low yields compared to other bonds. However, interest income earned from Treasuries is exempt from state and local taxes (but still subject to federal tax).

International government bonds

These are bonds issued by foreign governments, allowing investors to diversify their portfolios geographically while potentially benefiting from currency fluctuations. International government bonds can offer higher yields but also carry risks related to currency fluctuations and political instability.

Corporate bonds

Corporate bonds are issued by companies to raise capital for operations or strategic initiatives like expansion, product development, or acquisitions. There are two types of corporate bonds:

• Investment-grade bonds: These are issued by financially stable companies with a relatively low risk of default.
• High-yield bonds: Also known as junk bonds, these are issued by companies with lower credit ratings. They offer higher returns but carry more risk.

Corporate bonds usually pay interest semiannually and repay the principal at maturity. They offer higher yields compared to government bonds but come with additional credit risk.

Municipal bonds

Municipal bonds, or ‘munis’, are issued by states, cities, or local governments to fund project projects like building roads, schools, or bridges. They include:

• General obligation (GO) bonds: These are backed by the issuer’s taxing authority
• Revenue bonds: These are repaid from specific revenue sources, like toll roads or utilities
• Conduit bonds: These are issued on behalf of non-profits like hospitals or universities.

Interest earned on most municipal bonds is often exempt from federal income taxes (and sometimes state and local taxes). However, municipal bonds typically offer lower yields compared to corporate bonds.

Agency bonds

Agency bonds are issued by U.S. government-sponsored enterprises (GSEs), like the Federal National Mortgage Association (Fannie Mae) or the Federal Home Loan Mortgage Corporation (Freddie Mac), to fund their various lending programs.

These bonds don’t carry full U.S. government guarantees but are still considered to be high credit quality and low-risk. Interest payments on these bonds are subject to federal tax but may be exempt from state and local taxes depending on where you live.

Treasury Inflation-Protected Securities (TIPS)

TIPS are U.S. government bonds specifically designed to help protect investors from inflation. Unlike traditional Treasuries, the principal value of a TIPS bond adjusts over time based on changes in the Consumer Price Index (CPI).

When inflation rises, the value of a TIPS principal increases. During periods of deflation, the principal value is reduced. Interest payments are paid semiannually based on the adjusted principal. When the bond matures, investors receive either the adjusted principal or original principal (whichever is greater).

Emerging market bonds

Emerging market (EM) bonds are issued by governments, agencies, or companies in developing countries. They typically offer higher yields to compensate for higher risks, such as currency volatility, political instability, or weaker legal systems. Emerging market bonds can be denominated in U.S. dollars, local currencies, or another hard currency.

Preferred securities

Preferred securities are a hybrid of stocks and bonds. Like bonds, they usually make fixed interest payments (called dividends) and may be callable by the issuer after a certain date. Some preferred securities have very long maturities or are perpetual, meaning they have no maturity date at all.

Unlike bonds, however, dividend payments are often discretionary, meaning companies can skip them without triggering a default. Preferred shareholders also rank below bondholders in the event of bankruptcy (but above shareholders). Because of their additional risks and complexity, preferred securities usually offer higher yields.

Green bonds

Green bonds are issued to fund environmentally-friendly projects like renewable energy or pollution reduction. They function the same as regular bonds but give investors a way to earn interest while supporting sustainability initiatives.

Bond features

Some bonds come with special features that affect how they’re structured, how they pay interest, and when they can be redeemed.

Conditions applying to the bond

Different bonds offer different types of interest payments and terms:

• Fixed-rate bonds: These pay a set interest rate over the life of the bond. They’re the most common type of bond.
• Stepped-coupon bonds: These have increasing coupon payments over time, which can appeal to investors who expect interest rates to rise.
• Floating rate notes (FRNs): These have variable interest rates tied to a reference rate like LIBOR or Euribor. Their coupon rates reset periodically, like every 1 or 3 months.
• Zero-coupon bonds: These don’t make periodic interest payments. Instead, they’re sold at a discount to their face value and pay the full amount at maturity.
• Inflation-indexed bonds: These adjust both principal and interest payments on inflation (e.g. TIPS and I-Bonds).
• Lottery bonds: These are used by some European governments. They pay standard interest but randomly redeem certain bonds early (sometimes for more than face value).

Bonds with embedded options for the holder

Some bonds include features that provide additional flexibility for issuers or investors:

• Callable bonds: These give issuers the right to repay the bond early. This usually happens when interest rates fall, allowing issuers to refinance at a lower rate.
• Puttable bonds: These allow investors to sell the bond back to the issuer before maturity, usually at specific dates or times.
• Convertible bonds: These are corporate bonds that can be converted into a set number of shares of the issuing company’s stock.

Documentation and evidence of title

When an investor purchases a bond, they receive documentation that serves as proof of ownership. This can either be a physical certificate or electronic record through brokerage accounts. Documents include details like the bond’s par value, maturity date, interest rate, and any special provisions (such as those outlined above).

Retail bonds

Retail bonds are specifically designed for ordinary investors. They often have lower face values, simplified terms, and can easily be accessed through public offerings or brokerages.

Foreign currency bonds

Some bonds are issued or denominated in foreign currencies, which can expose investors to currency risk. If the foreign currency weakens against the investor’s home currency, they may see their returns reduced – even if the bond performs well. However, these bonds can be used to diversify internationally and take advantage of higher interest rates in certain countries.

Bond valuation

Bonds are valued based on interest rates, credit quality, time to maturity, and market demand. Even though a bond’s face value remains fixed, its market price can fluctuate after it has been issued.

How bonds are priced

Bonds in the secondary market can trade at a par, premium, or discount:

• Par: The bond’s face value (e.g. $1000)
• Premium: Above the bond’s face value (e.g. $1,100)
• Discount: Below the bond’s face value (e.g. 950).

This pricing can depend on various factors, including market interest rates, credit ratings, time to maturity, or investor demand.

Interest rates

Generally, bond prices move inversely to interest rates. For example, if a company issues a bond at $1,000 with a 5% coupon and interest rates rise, newly issued bonds might offer 5.5%. This means the original 5% bond will likely drop in price to stay competitive. The opposite is also true – if interest rates fall, older bonds with higher coupon rates become more valuable and can trade at a premium.

Credit ratings

Bonds from highly-rated issuers (like the U.S. Treasury or blue-chip companies) generally pay lower interest rates because they’re considered low-risk. Bonds from lower-rated issuers (sometimes called junk bonds) offer higher yields to compensate for the additional credit risk. We’ll discuss bond ratings in more detail a bit later in this article.

Yield to Maturity (YTM)

Yield to maturity (YTM) is one of the most important bond valuation tools, reflecting the total return an investor can expect to earn if the bond is held until maturity. This includes both coupon payments as well as any gain or loss if the bond was bought at a discount or premium.

YTM is expressed as an annual percentage rate and accounts for current market price, time remaining to maturity, coupon payments, and face value at maturity. If the YTM is higher than the coupon rate, the bond was purchased at a discount. If the YTM is less than the coupon rate, the bond was purchased at a premium.

Bond ratings

What are bond ratings?

Bond ratings help investors assess credit risk by measuring a bond issuer’s ability to meet its debt obligations. They’re issued by credit rating agencies like Moody’s Investors Service (Moody’s), Standard & Poor’s (S&P), and Fitch Ratings.

Bond ratings do not guarantee performance, repayment, or the suitability of an investment – they’re simply opinions of the credit rating agencies based on various factors. That said, they are a widely used tool that helps investors compare risk levels between different bonds.

How bond ratings work

The bond ratings process is similar to how credit bureaus assign credit scores to individuals. Credit rating agencies evaluate the issuer’s financial health, operating history, debt levels, and ability to generate income, amongst other factors, to determine the bond rating.

Each agency uses its own rating scale, but they generally align in how they categorise bonds from low-risk (investment grade) to high-risk (junk or speculative grade). Higher-rated bonds are considered safer, so they tend to have lower coupon ratings. Lower-rated bonds carry more risk, so offer higher yields to compensate for the possibility of default.

Bond ratings aren’t fixed and agencies regularly review issuers, upgrading or downgrading ratings as situations change. Downgrades can cause a bond’s price to fall while an upgrade might increase demand and raise the bond’s value.

Bond ratings chart

Investing in bonds

How to invest in bonds

There are three main ways to invest in bonds:

• New issues: Bonds can be purchased during their initial offerings through online brokerages. This is similar to buying a stock during an IPO – you buy the bond at face value before it trades on the open market.
• Secondary market: You can also buy or sell bonds after they’ve been issued, although prices on the secondary market may differ from face value based on interest rates and credit risk.
• Bond funds & ETFs: These are pooled investment vehicles that allow you to access a wide range of bonds without needing to buy them individually.

Key considerations for bond investors

Below are some important things to consider before you begin investing in bonds:

• Credit rating: As mentioned earlier, the credit rating indicates how likely the bond issuer is to repay its debt.
• Interest rates: Bond prices typically fall as market rates rise. Timing your purchase can make a difference, especially in a shifting rate environment.
• Maturity date: This tells you when you’ll get your principal back. Short-term bonds are more stable while long-term bonds might be more sensitive to interest rate changes.
• Yield vs price: Remember that bond prices and yields move in opposite directions. If the price of the bond drops, its yield rises because the fixed interest payment becomes a better deal relative to market rates.

Finding the right bond for you

The best bond investment for you depends on your financial goals, risk tolerance, and time horizon. Some investors prefer the stability and low-risk of Treasuries, while others are attracted to the higher income offered by corporate or high-yield bonds. For everyday investors, bond funds and ETFs can provide easy access and diversification without needing to spend time analyzing individual bonds.

Working with a financial advisor, or doing research through your brokerage, can help you find bonds that align with your unique investment goals.

Risks associated with bonds

Bonds are not risk-free investments. Let’s take a look at the common risks associated with bonds.

Interest rate risk

Interest rate risk is the risk that a bond’s value will fall as interest rates rise. When new bonds offer higher yields, older bonds with lower rates become less attractive, causing their prices to drop in the secondary market. If you need to sell the bond before maturity, this could mean that you end up receiving less than you paid for it.

Credit risk

Credit risk is the likelihood that the bond issuer may not be able to make interest payments or repay the principal at maturity. Even if the issuer doesn’t default outright, a credit rating downgrade can also reduce the bond’s price and make it harder to sell.

Call risk

Call risk applies to bonds with a callable feature, where the issuer can redeem the bond before maturity. These situations often occur when interest rates drop and the issuer wants to refinance at a lower rate. For investors, this could mean losing a bond that pays a higher interest rate and reinvesting in a bond with a lower return, essentially losing income.

Inflation risk

Inflation risk is the chance that inflation will erode the real value of your bond’s interest payments. Most bonds pay fixed interest, so if inflation rises, your income stays the same while the cost of goods goes up. TIPS are designed to help offset this risk.

Liquidity risk

Liquidity risk refers to how easily a bond can be bought or sold in the market without affecting its price. Some bonds – especially those from smaller issuers or less active markets – may be harder to sell quickly or at a fair price.

Currency risk

Currency risk is involved when investing in foreign bonds or bonds denominated in currencies other than the U.S. dollar. If the foreign currency weakens relative to the dollar, it can reduce the value of both your interest payments and the bond’s principal.

Benefits of bonds

Some of the potential benefits of investing in bonds include:

• Fixed income payments: Most bonds pay regular interest payments that can provide a reliable source of cash flow.
• Capital preservation: Bonds return the full face value when held to maturity, allowing investors to protect their principal while earning modest returns.
• Tax advantages: Some bonds offer tax benefits. For example, muni bonds are often exempt from federal income tax.
• Diversification: Bonds can help diversify a portfolio by reducing overall volatility, since they behave differently to stocks.

For bond issuers, like companies, governments, and municipalities, bonds are a way to raise money for operating expenses, refinance or pay off existing debt, or fund large-scale projects like expansion or infrastructure.

How to buy bonds

There are two main ways to buy bonds: directly purchasing individual bonds or investing through bond mutual funds or ETFs.

Via a mutual fund or ETF

Bond mutual funds or ETFs provide exposure to a broad portfolio of bonds without needing to buy the individual securities themselves. This provides easy diversification and allows investors to benefit from professional portfolio management. Bond ETFs are highly liquid and can be bought and sold like stocks throughout the trading day. However, investors pay management fees or expense ratios, which can reduce overall returns.

Purchasing individual bonds

Buying individual bonds gives investors direct ownership and control over the bond’s terms and returns. You can buy bonds through a brokerage, bank, or directly from the U.S. Treasury for Treasury bonds.

Bond indices

What are bond indices?

Bond indices are benchmarks used to measure the performance of specific segments of the bond market, similar to how stock indices track groups of equities. Each bond index is essentially a weighted list of selected bonds that reflects the broader performance of a bond market (e.g. government, corporate, or municipal bonds).

Bond indices are used for performance benchmarking, allowing investors and managers to compare how well their bond portfolios are performing. Many bond funds and ETFs also aim to replicate the performance of a bond index by holding a similar basket of bonds.

Some examples of bond indices include:

• Bloomberg U.S. Aggregate Bond Index: Benchmarks U.S. investment-grade bonds
• FTSE TMX Canada Universe Bond Index: Tracks investment-grade Canadian bonds
• ICE BofA U.S. High Yield Index: Measures the performance of U.S. high-yield corporate bonds

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