How Does the Bond Market Work?
Table of Contents
Unlike stocks, which are ownership shares in a company, bonds are a type of debt security. Various entities, ranging from federal and local governments to private corporations, may issue bonds to raise capital for infrastructure projects or company expansion.
Investors effectively loan money to the bond issuer in exchange for steady interest payments and a guaranteed return of principal when the bond matures.
For this reason, bonds are often described as fixed-income securities. And while there are bonds with higher and lower levels of risk, bonds in general are considered conservative investments because they are typically less volatile than stocks.
There is no bond market. Rather, bonds are issued over-the-counter via the primary market; they can also be bought and sold on the secondary market through a brokerage.
The bond market is vast and complex, comprising many different types of bonds and bond instruments (such as bond mutual funds and exchange-traded funds, or ETFs). Bonds can be used to provide income, support diversification, to help manage investment taxes, and more.
Key Points
• The bond market, or credit market, is where fixed-income securities are traded.
• A bond is basically a loan to a government, corporation, or other entity that promises to repay the loan, plus interest, by a certain date.
• Bonds can be bought on the primary market, from the bond issuer. Bonds can also be traded on the secondary market through a broker.
• While bonds are considered less risky than stocks, all bonds receive a rating from established credit agencies, which evaluate their creditworthiness.
• The bond market is vast and complex, and investors interested in bonds have a number of options to choose from, including bond mutual funds and ETFs.
What Are Bonds?
Just as individuals often need to take out loans in order to buy a home or a car, governments, cities, and companies also need to borrow money for operations or expansion. They can do this by selling bonds, a form of structured debt, and paying a specified amount of interest on them over time to the bondholder.
Essentially a bond is an interest-bearing IOU. An institution might need to borrow millions of dollars, but investors are able to lend them a lesser amount of that total loan by purchasing bonds. The reason an institution would choose to issue bonds instead of borrowing money from a bank is that they can often get better interest rates with bonds.
How Do Bonds Work?
Bonds are issued for a specific amount (the face value), and a certain length of time, called the “term to maturity.” A fixed amount of interest is paid to the investor every six months or year (known as the coupon rate), and the principal investment gets paid back at the end of the loan period, on what is called the maturity date.
In some cases, the interest is paid in a lump sum on the maturity date along with the principal.
For example, an investor could buy a $10,000 bond from a city, with a 10-year term that pays 2% interest. The city agrees to pay the investor $200 in interest every six months for the 10-year period, and will pay back the $10,000 principal at the end of the 10 years.
Bonds are generally issued when a government or corporation needs money for a specific purpose, such as developing infrastructure, making capital improvements or acquiring another business.
Investors can buy bonds directly through a government site, or via a brokerage or an online investing platform.
Holding Bonds and Trading Bonds
Investors who purchase bonds have the option of holding the bond to maturity, and then collecting the interest and the principal when they redeem the bond. But it’s also possible to buy and sell bonds.
Trading bonds requires a deeper understanding of how bond values change, based on the time left to maturity and the interest or coupon rate. The face value or par value of a bond — its value when it was issued — doesn’t change, exactly, nor does the coupon rate.
Similar to investing in stocks, the price you pay for bonds on the secondary market fluctuates, depending on various factors — including its yield and maturity. A bond with a longer maturity might be less attractive than a bond with a shorter maturity, owing to the risk of interest rates changing, for example. This is why longer-term bonds typically offer higher yields.
Recommended: How to Buy Bonds: A Guide for Beginners
Primary vs Secondary Bond Markets
Bonds are sold in two different markets: the primary market and the secondary market. But bonds are not traded on exchanges; they’re sold over-the-counter.
Newly issued bonds are sold on the primary market, where sales happen directly between issuers and investors. Investors who purchase bonds may then choose to sell them before they reach maturity, using the secondary market (brokerages). One may also choose to purchase bonds in the secondary market rather than only buying new issue bonds.
Bonds in the secondary market are priced based on their interest rate, their maturity date, and their bond rating (more on that below).
Differences in Bonds
Bond terms and features vary depending on the type and who issues them. The main types of bonds are:
U.S. Treasury Securities
These government-issued bonds are considered among the safer types of fixed-income investments: they are backed by the full faith and credit of the U.S. government, which has yet to default on its debts. There are three main types of Treasury securities.
• Treasury Bills, or T-Bills. These short-term Treasuries have maturity terms of four, eight, 13, 26, and 52 weeks. T-bills don’t pay a coupon rate; rather, investors buy T-bills at a discount to their face value. On maturity, investors get the full face or par value. The difference between purchase and redemption acts as a modest interest payment.
The sale of T-bills funds most government functions. These bonds are subject to federal income taxes, but are exempt from local and state income taxes.
• Treasury Notes, or T-Notes. T-notes are sold at longer maturities of two, three, five, seven, and 10-year terms. These longer maturities pay a higher rate.
• Treasury Bonds, or T-Bonds. This 30-year government bond is typically known as the long bond, and is similar to the T-note, except with a much longer maturity.
Treasury notes and bonds are issued at $100 par value per bond, with bond interest rates depending on the current environment.
Recommended: How to Buy Treasury Bills, Bonds, and Notes
Treasury Inflation-Protected Securities (TIPS)
These government bonds specifically protect against inflation, because the principal or purchase amount adjusts according to changes in the Consumer Price Index — either higher or lower, on a semi-annual basis. The coupon rate remains fixed, however.
At maturity, investors can redeem the bond for the original principal amount or the adjusted principal, whichever is greater. The bond is inflation protected in that the bondholder cannot lose their original principal.
Municipal Bonds
Also known as muni bonds, these securities are issued by cities and towns to fund projects like hospitals, roads, schools, and public utilities. They are somewhat riskier than Treasury bills, but muni bonds are exempt from federal taxes, and often state taxes as well.
As a result, munis generally pay a slightly lower rate than, say, corporate bonds or other taxable fixed-income securities.
U.S. Agency Bonds
U.S. agency bonds are debt obligations sold by government-sponsored enterprises (GSEs). While these are not fully backed by the U.S. government like Treasuries, agency bonds are offered by large federal agencies such as Freddie Mac and Fannie Mae, the Tennessee Valley Authority, the Federal Farm Credit Bank, and so on.
These bonds can offer a higher yield than Treasuries, depending on the maturity, without incurring substantially more risk than Treasuries.
Corporate Bonds
Riskier bond types are those issued by companies. The reason they have more risk is that companies can’t raise taxes to pay back their debts, the way a government might, and companies generally have some risk of failure.
The interest rate on corporate bonds depends on the company. These bonds typically have a maturity of at least one year, and they are subject to federal and state income taxes.
Junk Bonds
Corporate bonds with the highest risk, and generally higher potential return, are called junk bonds or high-yield bonds. All bonds get rated from a high of triple-A down to junk bonds — more on bond ratings below.
Junk bonds are so called because the bond issuer has a lower credit rating than another company, which means there is a risk the investor could lose their principal if the company defaults. Junk bonds pay higher coupon rates to appeal to investors, and help offset some of that risk.
Convertible Bonds
Convertible bonds are a type of hybrid security issued by a corporation, which can be converted into stock at certain times throughout the term of the bond.
Convertible bonds, which pay a fixed coupon rate, can offer downside protection during times of stock volatility. And when the stock market is on an upswing, investors have the option to convert their bonds into shares.
There is no obligation to convert a convertible bond, however, and investors can hold the bond to maturity, collecting regular interest payments, and receive their principal at maturity.
Mortgage-Backed Securities (MBS)
These securities are different from traditional bonds, where investors lend their money to the bond issuer, who repays it based on agreed-upon terms. Mortgage-backed securities give investors a claim on the cash flow and interest payments from mortgages that have been pooled together by public or private entities, and sold as securities.
Ginnie Mae (short for the Government National Mortgage Association) is the U.S. government agency that issues most mortgage-backed securities. In addition, Freddie Mac and Fannie Mae, both U.S. government-sponsored enterprises (GSEs), also issue MBSs.
MBSs can be risky when mortgage holders default on their loans, but these securities can offer a steady yield that’s relatively high compared with other bonds. The GSEs that offer mortgage-backed securities offer certain repayment guarantees that help manage risk.
Foreign Bonds
Similar to U.S. bonds, investors can also purchase bonds issued in other countries. Similar to domestic bonds, these are generally issued in the local currency by governments or corporations. Bear in mind that these bonds carry the additional risk of currency fluctuations.
While it’s possible to invest in foreign bonds via a self-directed brokerage account, it’s also possible to invest in mutual funds or ETFs that have a portfolio of foreign bonds.
Emerging Market Bonds
Companies and governments in emerging markets issue bonds to help with continued economic growth. These bonds have potential for growth, and often provide higher yields as a result, but can also be riskier than investing in developed market economies.
Zero-Coupon Bonds
Zero-coupon bonds don’t make regular interest payments, but are sold at a steep discount to their face value.
Investors earn a profit when the bond reaches maturity because they receive the full face value of the bond at the maturity date. For example, a zero-coupon bond with a face value of $10,000 and a five-year maturity might be sold at a discount for $8,000. When the bond matures after five years, the investor would get $10,000 — getting the equivalent of a 4% coupon rate.
Bond Funds
Investors can also buy into bond mutual funds or bond ETFs, which are portfolios of different types of bonds collected into a single fund — similar to the way equity funds are based on a portfolio of stocks. There are bond funds that hold a portfolio of corporate bonds, government bonds, or other types of bonds.
These funds are generally managed by a fund manager, but some bond funds are index funds in that they’re passively managed and track one of the many bond indices.
Bond funds can be safer than individual bonds, since they diversify money into many different bonds.
Recommended: How to Buy Bonds: A Guide for Beginners
What to Consider When Choosing Bonds
When investors are looking into stocks to invest in, the differences are mainly in the prospects of the company, the team, and the company’s products and services. Bonds, on the other hand, can have significantly different terms and features. For this reason, it’s important for investors to have some understanding of how bonds work before they begin to invest in them.
The main features to look at when selecting bonds are:
Coupon
This is the fixed interest rate paid to investors based on the face value, and it determines the annual or semi-annual coupon payment. For example, if an investor buys a $1,000 bond with a 3% coupon rate, the coupon payment is $30/year.
Face Value
Also referred to as “par,” this is the price of the bond when it’s issued. Usually bonds have a starting face value of $1,000. If a bond sells in the secondary market for higher than its face value, this is known as “trading at a premium,” while bonds that sell below face value are “trading at a discount.”
Maturity
The maturity date tells an investor the length of the bond term. This helps the buyer know how long their money will be tied up in the bond investment. Also, bonds tend to decrease in value as they near their maturity date, so if a buyer is looking at the secondary market it’s important to pay attention to the maturity date.
Bond maturity dates fall into three categories:
• Short-term: Bonds that mature within 1-3 years.
• Medium-term: Bonds that mature around 10 years.
• Long-term: These bonds could take up to 30 years to mature.
Yield
This is the total return rate of the bond. Although a bond’s interest rate is fixed, its yield can change since the price of the bond changes based on market fluctuations. There are a few different ways yield can be measured:
• Yield to Maturity (YTM): Yield to maturity refers to the total return of a bond if all interest gets paid and it is held until its maturity date. YTM assumes that interest earned on the bond gets reinvested at the same rate of the bond, which is unlikely to actually happen, so the actual return will differ somewhat from the YTM.
• Current Yield: This calculation can help bondholders compare the return they are getting on different bonds, as well as other securities. You can calculate current yield by dividing the bond’s coupon by its current price. A $1,000 bond that pays $50 has a current yield of 5%.
• Nominal Yield: This is the percentage of interest that gets paid out on the bond within a certain period of time. Since the current value of a bond changes over time, but the nominal yield calculation is based on the bond’s face value, the nominal yield isn’t always useful.
• Yield to Call (YTC): Some bonds may be called before they reach maturity. Bondholders can use the YTC calculation to estimate what their earnings will be if the bond gets called.
• Realized Yield: This is a calculation used if a bondholder plans to sell a bond in the secondary market at a particular time. It tells them how much they will earn on the bond between the time of the purchase and the time of sale.
Price
This is the value of a bond in the secondary market. There are two bond prices in the secondary market: bidding price and asking price. The bidding price is the highest amount a buyer is willing to pay for a specific bond, and the asking price is the lowest price a bondholder would be willing to sell the bond for.
Bond prices change as interest rates change, along with other factors, so it’s important to understand bond valuation.
Rating
As mentioned above, all bonds and bond issuers are rated by bond rating agencies. The rating of a bond helps investors understand the risk and potential earnings associated with a bond. Bonds and bond issuers with lower ratings have a higher risk of default.
Ratings are done by three bond rating agencies: Standard & Poor’s, Moody’s, and Fitch. Fitch and Standard & Poor’s rate bonds from AAA down to D, while Moody’s rates from Aaa to C.
Bond Market Terminology
When buying bonds, there are a few terms which investors may not be familiar with. Some of the key terms to know include:
• Duration Risk: This is a calculation of how much a bond’s value may fluctuate when interest rates change. Longer term bonds are at more risk of value fluctuations.
• Liquidation Preference: If a company goes bankrupt, investors get paid back in a specific order as the company sells off assets. Depending on the type of investment, an investor may or may not get their money back. Companies pay back “Senior Debt” first, followed by “Junior Debt.”
• Puttable Bonds: Some bonds allow the bondholder to redeem their principal investment before the maturity date, at specific times during the bond term.
• Secured vs. Unsecured
◦ Secured bonds are backed by collateral whereas unsecured bonds are not. One type of secured bond is a mortgage-backed security, which is secured with real estate collateral. Secured bonds are slightly lower risk than unsecured bonds, which are not backed by tangible assets, and as such tend to pay a lower rate.
◦ Unsecured bonds, also known as debentures, are not backed by any assets, so if the company defaults on the loan the investor loses their money. The other difference between secured and unsecured bonds is the lower credit rating and the higher rate unsecured bonds may offer to be more attractive to investors.
The Bond Market and Stocks
There is an inverse correlation between the bond market and the stock market, and the performance of the secondary bond market often reflects people’s perceptions of the stock market and the overall economy.
When investors feel good about the stock market, they are less likely to buy bonds, since bonds provide lower returns and require long-term investment. But when there’s a negative outlook for the stock market, investors want to put their money into safer assets, such as bonds.
How to Make Money on Bonds
While one way to make money on bonds is to hold them until their maturity to receive the principal investment plus interest, there is also another way investors can make money on bonds.
As mentioned above, bonds can be sold on the secondary market any time before their maturity date. If an investor sells a bond for more than they paid for it, they make a profit.
There are two reasons the price of a bond might increase. If newly issued bonds come out with lower interest rates, then bonds that had been previously issued with higher interest rates go up in value. Or, if the credit risk profile of the government or corporation that issued the bonds improves, that means the institution will be more likely to be able to repay the bond, so its value increases.
Potential Advantages of Bonds
There are several reasons that bonds may be an attractive investment.
• Predictable Income: Since bonds are sold with a fixed interest rate, investors know exactly how much they will earn from the investment.
• Security: Although bonds offer lower return rates than most stocks, they generally don’t have the volatility and risk.
• Contribution: The funds raised from the sale of bonds may go towards improving cities, towns, and other community features. By investing in bonds, one is supporting community improvements.
• Diversification: Bonds can provide diversification. Building a diversified portfolio can help manage portfolio risk.
• Obligation: There is no guarantee of payment when investing in stocks. Bonds are a debt obligation that the issuer has agreed to pay.
• Profit on Resale: Investors have the opportunity to resell their bonds in the secondary market and potentially make a profit.
Potential Disadvantages of Bonds
Bonds also come with potential risk factors to consider.
• Lack of Liquidity: Investors can sell bonds before their maturity date, but they may not be able to sell them at the same or higher price than they bought them for. If they hold on to the bond until its maturity, that cash may not be available for use for a long period of time.
• Bond Issuer Default and Credit Risk: Most bonds are considered low risk, but there is a possibility that the issuer won’t be able to pay back the loan. If this happens, the investor may not receive their principal or interest.
• Low Returns: Bonds offer fairly low interest rates, so in the long run investors are likely to see higher returns in the stock market. In some cases, the bond rate may even be lower than the rate of inflation.
• Market Changes: Bonds can decrease in value if the issuing corporation’s bond rating changes, if the company’s prospects don’t look good, or it looks like they may ultimately default on the loan.
• Interest Rate Changes: One of the most important things to understand about bonds is that their value has an inverse relationship with interest rates. If interest rates increase, the value of bonds decreases, and vice versa. The reason for this is that if interest rates rise on new bond issues, investors would prefer to own those bonds than older bonds with lower rates. If a bond is close to reaching maturity it will be less affected by changing interest rates than a bond that still has many years left to mature.
• Not FDIC Insured: There is no FDIC insurance for bondholders. If the issuer defaults, the investor loses the money they invested.
• Call Provision: Sometimes corporations have the option to redeem bonds. This isn’t a major downside, but does mean investors receive their money back and will be able to reinvest it.
How to Buy Bonds
Bonds differ from stocks in that, for the most part, they aren’t traded publicly on an exchange. Investors can buy bonds directly from an issuing entity, such as a government or company. And they can also buy and sell bonds on the secondary market, through a brokerage.
When using a broker, it’s important for investors to research to make sure they are getting a good price. They can also check the Financial Industry Regulatory Authority (FINRA) to see benchmark data, and get an idea about how much they should be paying for a particular bond. FINRA also has a search tool for investors to find credible bond brokers.
As mentioned above, traders can either buy bonds in the primary or secondary market, or they can buy into bond mutual funds and bond ETFs.
The Takeaway
Many investors focus on the performance of the stock market owing to its volatility and its capacity to make headlines. But the global bond market is actually far larger — with a $140 trillion capitalization, versus $115 trillion for the global stock market, as of the end of 2023.
The bond market may be complex, but it can be rewarding. And bonds tend to have a lower risk profile compared with stocks. As such, bonds can play an important role in investors’ portfolios, owing to their potential to provide steady income as well as diversification.
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FAQ
Do all bonds pay interest?
No. Most bonds pay a coupon rate, a fixed interest payment every year or every six months. But zero-coupon bonds are sold at a discount to their face value, for example, and rather than pay interest these bonds can be redeemed at maturity for the full face value — effectively providing a fixed return.
Can you lose money with a bond?
Yes, bonds may be less risky than stocks, but you can still lose money with bonds. For example, a high-yield or junk bond may promise higher rates, but these bonds are at a higher risk of defaulting. It’s also possible to lose money on bonds when interest rates fluctuate, potentially reducing the value of the bonds you’d hoped to sell.
What is the coupon rate versus the coupon payment?
The coupon rate of a bond is the interest rate that’s set when the bond is issued. For example, you might buy a $1,000 bond with a 3% coupon rate. The annual coupon payment is the % rate x the face value (0.03 x $1,000) or $30 per year.
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