Treasury securities of all lengths provide a nearly guaranteed source of income and hold their value in just about every economic environment. A corporate bond is a debt instrument issued by a business to raise money. Unlike a stock offering, with which investors buy a stake in the company itself, a bond is a loan with a fixed term and an interest yield that investors will earn.
When it matures, or reaches the end of the term, the company repays the bond holder. Investing Best Accounts. Stock Market Basics. Stock Market. Industries to Invest In. Getting Started. Planning for Retirement. Retired: What Now? Personal Finance. Credit Cards. About Us. Who Is the Motley Fool? Fool Podcasts. New Ventures. Search Search:. Dan Caplinger. How do bonds work?
How to make money from bonds There are two ways to make money by investing in bonds. The first is to hold those bonds until their maturity date and collect interest payments on them. Bond interest is usually paid twice a year. The second way to profit from bonds is to sell them at a price that's higher than what you pay initially. Bond prices can rise for two main reasons. If the borrower's credit risk profile improves so that it's more likely to be able to repay the bond at maturity, then the price of the bond typically rises.
Also, if prevailing interest rates on newly issued bonds go down, then the value of an existing bond at a higher rate goes up. An investor who buys a government bond is lending the government money. If an investor buys a corporate bond, the investor is lending the corporation money.
Like a loan, a bond pays interest periodically and repays the principal at a stated time, known as maturity. To set the coupon, the issuer takes into account the prevailing interest rate environment to ensure that the coupon is competitive with those on comparable bonds and attractive to investors.
How long it takes for a bond to reach maturity can play an important role in the amount of risk as well as the potential return an investor can expect. The additional risk incurred by a longer-maturity bond has a direct relation to the interest rate, or coupon, the issuer must pay on the bond. In other words, an issuer will pay a higher interest rate for a long-term bond. An investor therefore will potentially earn greater returns on longer-term bonds, but in exchange for that return, the investor incurs additional risk.
Independent credit rating services assess the default risk, or credit risk, of bond issuers and publish credit ratings that not only help investors evaluate risk, but also help determine the interest rates on individual bonds. An issuer with a high credit rating will pay a lower interest rate than one with a low credit rating.
Again, investors who purchase bonds with low credit ratings can potentially earn higher returns, but they must bear the additional risk of default by the bond issuer. Yield is therefore based on the purchase price of the bond as well as the coupon. When prevailing interest rates fall — notably, rates on government bonds — older bonds of all types become more valuable because they were sold in a higher interest rate environment and therefore have higher coupons.
The easiest way to understand bond prices is to add a zero to the price quoted in the market. Most bonds are issued slightly below par and can then trade in the secondary market above or below par, depending on interest rate, credit or other factors. Put simply, when interest rates are rising, new bonds will pay investors higher interest rates than old ones, so old bonds tend to drop in price.
Falling interest rates, however, mean that older bonds are paying higher interest rates than new bonds, and therefore, older bonds tend to sell at premiums in the market. On a short-term basis, falling interest rates can boost the value of bonds in a portfolio and rising rates may hurt their value.
Conversely, in a falling interest rate environment, money from maturing bonds may need to be reinvested in new bonds that pay lower rates, potentially lowering longer-term returns.
The inverse relationship between price and yield is crucial to understanding value in bonds. Duration, like the maturity of the bond, is expressed in years, but as the illustration shows, it is typically less than the maturity.
For a zero-coupon bond, maturity and duration are equal since there are no regular coupon payments and all cash flows occur at maturity. Because of this feature, zero-coupon bonds tend to provide the most price movement for a given change in interest rates, which can make zero-coupon bonds attractive to investors expecting a decline in rates.
The end result of the duration calculation, which is unique to each bond, is a risk measure that allows investors to compare bonds with different maturities, coupons and face values on an apples-to-apples basis. Duration provides the approximate change in price that any given bond will experience in the event of a basis-point one percentage point change in interest rates. The weighted average duration can also be calculated for an entire bond portfolio, based on the durations of the individual bonds in the portfolio.
Since governments began to issue bonds more frequently in the early twentieth century and gave rise to the modern bond market, investors have purchased bonds for several reasons: capital preservation, income, diversification and as a potential hedge against economic weakness or deflation.
When the bond market became larger and more diverse in the s and s, bonds began to undergo greater and more frequent price changes and many investors began to trade bonds, taking advantage of another potential benefit: price, or capital, appreciation. Today, investors may choose to buy bonds for any or all of these reasons.
Capital preservation : Unlike equities, bonds should repay principal at a specified date, or maturity. This makes bonds appealing to investors who do not want to risk losing capital and to those who must meet a liability at a particular time in the future.
Bonds have the added benefit of offering interest at a set rate that is often higher than short-term savings rates. On a set schedule, whether quarterly, twice a year or annually, the bond issuer sends the bondholder an interest payment, which can be spent or reinvested in other bonds.
Stocks can also provide income through dividend payments, but dividends tend to be smaller than bond coupon payments, and companies make dividend payments at their discretion, while bond issuers are obligated to make coupon payments. Capital appreciation : Bond prices can rise for several reasons, including a drop in interest rates and an improvement in the credit standing of the issuer. However, by selling bonds after they have risen in price — and before maturity — investors can realize price appreciation, also known as capital appreciation, on bonds.
Capturing the capital appreciation on bonds increases their total return, which is the combination of income and capital appreciation. Investing for total return has become one of the most widely used bond strategies over the past 40 years. Diversification : Including bonds in an investment portfolio can help diversify the portfolio. Many investors diversify among a wide variety of assets, from equities and bonds to commodities and alternative investments, in an effort to reduce the risk of low, or even negative, returns on their portfolios.
Potential hedge against an economic slowdown or deflation : Bonds can help protect investors against an economic slowdown for several reasons. The price of a bond depends on how much investors value the income the bond provides. Inflation usually coincides with faster economic growth, which increases demand for goods and services. On the other hand, slower economic growth usually leads to lower inflation, which makes bond income more attractive. An economic slowdown is also typically bad for corporate profits and stock returns, adding to the attractiveness of bond income as a source of return.
Treasury bonds, directly from the government. In addition to purchasing bonds directly, you can also invest in a bond fund. Bond funds give you access to various types of bonds so you can invest in a mix. When you sign up for a robo-advisor, you'll take a survey to assess your risk. Then the service's algorithm will recommend the best portfolio for your financial needs, which will often include a mix of stocks and bonds.
Select reviewed dozens of robo-advisors and our top pick, Betterment , and the runner-up, Wealthfront , both offer a mix of stocks and bonds in their portfolios. When shopping around for a broker, consider cross-referencing BrokerCheck , which can be a helpful resource to make sure a broker is credible.
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