What Are Bonds and How Do They Work?

A bond is a loan to a company or government. It pays investors a fixed rate of return. See how they may work for you.
Definition: What Is a Bond?

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In simple terms, a bond is loan from an investor to a borrower such as a company or government. The borrower uses the money to fund its operations, and the investor receives interest on the investment. The market value of a bond can change over time.

A bond is a fixed-income instrument, which is one of the three main , or groups of similar investments, frequently used in investing.

Most investment portfolios should include some bonds, which help balance out risk over time. If , bonds can help cushion the blow.

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Key facts about bonds

Bonds, like many investments, balance risk and reward. Typically, bonds that are lower risk pay lower interest rates; bonds that are riskier pay higher rates in exchange for the investor giving up some safety. There are different types of bonds.

are backed by the federal government and are considered one of the safest types of investments. The flip side of these bonds is their low interest rates. There are several types of Treasury bonds (bills, notes, bonds) that differ based upon the length of time till maturity as well as Treasury Inflation-Protected Securities or TIPS.

Companies can issue corporate bonds when they need to raise money.

, also called munis, are issued by states, cities, counties and other nonfederal government entities. Similar to how corporate bonds fund company projects or ventures, municipal bonds fund state or city projects, like building schools or highways.

Municipal bonds can have tax benefits. Bondholders may not have to pay federal taxes on the interest, which can translate to a lower interest rate from the issuer. Muni bonds may also be exempt from state and local taxes if they're issued in the state or city where you live.

Municipal bonds can vary in term: Short-term bonds repay their principal in one to three years, while long-term bonds can take over ten years to mature.

» Interested in giving a bond as a gift? Read

Bonds work by paying back a regular amount to the investor, also known as a “coupon rate,” and are thus referred to as a type of fixed-income security. For example, a $10,000 bond with a 10-year maturity date and a coupon rate of 5% would pay $500 a year for a decade, after which the original $10,000 face value of the bond is paid back to the investor.

» Ready to add bonds to your portfolio? See our guide on 

Like any investment, bonds have pros and cons.

Bonds are relatively safe. Bonds can create a balancing force within an investment portfolio: If you have a majority invested in stocks, adding bonds can and lower your overall risk. And while bonds do carry some risk (such as the issuer being unable to make either interest or principal payments), they are generally much less risky than stocks.

Bonds are a form of fixed-income. Bonds pay interest at regular, predictable rates and intervals. For retirees or other individuals who like the idea of receiving regular income, bonds can be a solid asset to own.

Low interest rates. Unfortunately, with safety comes lower interest rates. Long-term government bonds have historically earned about 5% in average annual returns, while the stock market has historically returned 10% annually on average.

Some risk. Even though there is typically less risk when you over stocks, bonds are not risk-free. For example, there is always a chance you’ll have difficulty selling a bond you own, particularly if interest rates go up. The bond issuer may not be able to pay the investor the interest and/or principal they owe on time, which is called default risk. Inflation can also reduce your purchasing power over time, making the fixed income you receive from the bond less valuable as time goes on.

» How does inflation affect your money? Learn more about purchasing power with our

Bonds, when used strategically alongside stocks and other assets, can be a great addition to your investment portfolio, many financial advisors say. Unlike stocks, which are purchased shares of ownership in a company, bonds are the purchase of a company or public entity’s debt obligation.

Stocks earn more interest, but they carry more risk, so the more time you have to ride out market fluctuations, the higher your concentration in stocks can be. But as you near retirement and have  that might erode your nest egg, you'll want more bonds in your portfolio.

If you’re in your 20s, 10% of your portfolio might be in bonds; by the time you’re 65, that percentage is likely to be closer to 40% or 50%.

Another difference between stocks and bonds is the potential tax breaks, though you can get those breaks only with certain kinds of bonds, such as municipal bonds.

And even though bonds are a much safer investment than stocks, they still carry some risks, like the possibility that the borrower will go bankrupt before paying off the debt.

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With bond basics under your belt, keep reading to learn more about:

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