How Bonds Work

Bonds are an essential component of many investment portfolios, providing stability, income, and diversification. However, to fully appreciate their role and potential, it's important to first understand the fundamentals of what bonds are and how they function. Whether issued by governments or private corporations, bonds are a versatile tool for raising capital and offering investors predictable returns. This article explores the mechanics of bonds, including how they are traded, priced, and affected by market conditions, to help you learn about this key asset class.

Bond Issuers

Both governments and private corporations issue bonds to raise funds, and they are purchased by investors seeking an investment return on their capital. Bonds represent a promise—a contractual obligation—to make specific payments over time on specific dates. Typically, this includes interest payments made on a semi-annual basis until the maturity date and the return of the bond’s face value.

Treasuries are issued by the U.S. government. Technically, Treasuries with maturities of a year or less are called “bills,” while those with maturities of more than a year up to ten years are called “notes,” while “bonds” typically refer to treasuries with maturities of more than ten years. This article will generally refer to all these vehicles as “bonds” for easy reference.

Bank CDs also function as a type of bond in terms of providing specified cash flows at specified dates.

Bond Interest Rates

Bond interest rates—both coupon rates and the yields subsequently provided to investors—are determined by the interaction of supply and demand for the bonds as they continue to be traded. An increase in demand—such as that triggered by a “flight to quality” when investors are panicked by the falling prices of risky assets—will push up the price of these bonds. Conversely, a stretched government seeking to raise funds through an increasing supply of new bond issues will reduce the price of bonds.

Among the universe of bonds, there is not one single interest rate. Differences in interest rates among bonds reflect several factors:

• the time to maturity for the bond (longer-term bonds will experience more price volatility as interest rates change),
• the credit risk of the bond (bonds that are more likely to default on their promised payments are riskier and will have to reward investors with higher yields),
• liquidity (bonds that are more actively traded may offer lower yields), and
• the tax status of the bond (municipal bonds from state and local government agencies are free from federal income taxes and thus offer lower interest rates).

Trading Bonds

Newly issued bonds are sold on the primary market, but many go on to be traded on secondary markets. Before we explain how the trading process works, it is helpful to understand these key terms:

• Par value: The price equal to the bond’s face value
• Premium: A bond that sells for more than face value
• Discount: A bond that sells for less than face value
• Bid: The price the bond can be sold for
• Ask: The price at which someone is willing to purchase
• Spread: The difference in price between what buyers will pay and what sellers will accept, which is paid to the party brokering the exchanges between buyers and sellers.

Rising interest rates will lower prices for existing bonds. Conversely, lower interest rates will increase the price for which existing bonds can sell. The price of a bond on the secondary market will fluctuate in the opposite direction of interest rates. Bonds may also feature other options that affect the price an investor is willing to pay. For instance, if the bond is “callable” (meaning the issuer retains the right to repay it early if interest rates decline), the potential capital gains are reduced, which in turn lowers the price investors are willing to pay.

U.S. government Treasuries are generally seen as having the lowest credit risk, and will generally offer lower yields than corporate bonds with the same maturity date. They are less likely to default and create problems for borrowers to receive what is owed. Treasuries are backed by the full faith and credit of the U.S. government. They are also not subject to state and local taxes.

In recent years, financial innovation has led to the creation of many new types of fixed-income instruments with varying risk and return potential, but the discussion here is about using traditional government or non-callable (face value cannot be repaid early) high-quality corporate bonds to support a retirement income strategy.

Understanding the basics of bonds is the first step in leveraging their potential to meet your financial goals. From Treasuries to corporate bonds, the interplay of factors like interest rates, maturity, credit risk, and tax status influences their performance and value in a portfolio. For retirees or those nearing retirement, high-quality bonds offer a reliable option to generate income while mitigating market volatility.