What is a Bond and How do they Work? | Vanguard (2024)

Types of bonds

Companies can issue bonds, but most bonds are issued by governments. Because governments are generally stable and can raise taxes if needed to cover debt payments, these bonds are typically higher-quality, although there are exceptions.

U.S. Treasuries

These are considered the safest possible bond investments.

You'll have to pay federal income tax on interest from these bonds, but the interest is generally exempt from state tax. Because they're so safe, yields are generally the lowest available, and payments may not keep pace with inflation. Treasuries are extremely liquid.

Certain types of Treasuries have specific characteristics:

  • Treasury bills have maturities of 1 year or less. Unlike most other bonds, these securities don't pay interest. Instead, they're issued at a "discount"—you pay less than face value when you buy it but get the full face value back when the bond reaches its maturity date.
  • Treasury notes have maturities between 2 years and 10 years.
  • Treasury bonds have maturities of more than 10 years—most commonly, 30 years.
  • Treasury Inflation-Protected Securities (TIPS) have a return that fluctuates with inflation.


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Do you need income that fluctuates with inflation? Learn more about our TIPS funds.

  • Separate Trading of Registered Interest and Principal of Securities (STRIPS) are essentially Treasuries that have had their coupon payments "stripped" away, meaning that the coupon and face value portions of the bond are traded separately.
  • Floating rate notes have a coupon that moves up and down based on the coupon offered by recently auctioned Treasury bills.

Read more about Treasury securities

Government agency bonds

Some agencies of the U.S. government can issue bonds as well—including housing-related agencies like the Government National Mortgage Association (GNMA or Ginnie Mae). Most agency bonds are taxable at the federal and state level.

These bonds are typically high-quality and very liquid, although yields may not keep pace with inflation. Some agency bonds are fully backed by the U.S. government, making them almost as safe as Treasuries.

Because mortgages can be refinanced, bonds that are backed by agencies like GNMA are especially susceptible to changes in interest rates. The families holding these mortgages may refinance (and pay off the original loans) either faster or slower than average depending on which is more advantageous.

If interest rates rise, fewer people will refinance and you (or the fund you're investing in) will have less money coming in that can be reinvested at the higher rate. If interest rates fall, refinancing will accelerate and you'll be forced to reinvest the money at a lower rate.

Read more about agency bonds

Municipal bonds

These bonds (also called "munis" or "muni bonds") are issued by states and other municipalities. They're generally safe because the issuer has the ability to raise money through taxes—but they're not as safe as U.S. government bonds, and it is possible for the issuer to default.

Interest from these bonds is free from federal income tax, as well as state tax in the state in which it's issued. Because of the favorable tax treatment, yields are generally lower than those of bonds that are federally taxable.

Read more about municipal bonds

Corporate bonds

These bonds are issued by companies, and their credit risk ranges over the whole spectrum. Interest from these bonds is taxable at both the federal and state levels. Because these bonds aren't quite as safe as government bonds, their yields are generally higher.

High-yield bonds ("junk bonds") are a type of corporate bond with low credit ratings.

Read more about corporate bonds

Inflation

A general rise in the prices of goods and services.

Liquidity

A measure of how quickly and easily an investment can be sold at a fair price and converted to cash.

What is a Bond and How do they Work? | Vanguard (2024)

FAQs

What is a Bond and How do they Work? | Vanguard? ›

Bonds can be issued by companies or governments and generally pay a stated interest rate. The market value of a bond changes over time as it becomes more or less attractive to potential buyers. Bonds that are higher-quality (more likely to be paid on time) generally offer lower interest rates.

What are bonds and how do they work? ›

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.

What is the best explanation of a bond? ›

A bond is simply a loan taken out by a company. Instead of going to a bank, the company gets the money from investors who buy its bonds. In exchange for the capital, the company pays an interest coupon, which is the annual interest rate paid on a bond expressed as a percentage of the face value.

What is a bond quizlet? ›

A bond is a fixed income instrument that represents a loan made by an investor to a borrower (typically corporate or governmental)

How do bonds work together? ›

Ionic bonds transfer an electron(s) and are held together by electrostatic force. Covalent bonds share electron pairs between atoms. When two atoms with large differences in electronegativity react, there is a transfer of electrons from the less electronegative atom to the more electronegative atom.

How do we bonds work? ›

Series EE savings bonds are a low-risk way to save money. They earn interest regularly for 30 years (or until you cash them if you do that before 30 years). For EE bonds you buy now, we guarantee that the bond will double in value in 20 years, even if we have to add money at 20 years to make that happen.

What is the definition of a bond? ›

Bonds are investment securities where an investor lends money to a company or a government for a set period of time, in exchange for regular interest payments. Once the bond reaches maturity, the bond issuer returns the investor's money.

What is a bond answer? ›

A bond is a fixed-income instrument and investment product where individuals lend money to a government or company at a certain interest rate for an amount of time.

Are bonds a good investment now? ›

Short-term bond yields are high currently, but with the Federal Reserve poised to cut interest rates investors may want to consider longer-term bonds or bond funds. High-quality bond investments remain attractive.

How do you make money with bonds? ›

You can make money on a bond from interest payments and by selling it for more than you paid. You can lose money on a bond if you sell it for less than you paid or the issuer defaults on their payments.

What is a term bond in simple terms? ›

A term bond refers to the issuance of bonds that are repaid at the same time. Term bonds can be short-term or long-term, with the latter having longer maturity dates than the former.

What is a bond best defined as? ›

In finance, a bond is a type of security under which the issuer (debtor) owes the holder (creditor) a debt, and is obliged – depending on the terms – to provide cash flow to the creditor (e.g. repay the principal (i.e. amount borrowed) of the bond at the maturity date as well as interest (called the coupon) over a ...

What are the three main components of a bond? ›

Key Points
  • The three basic components of a bond are its maturity, its face value, and its coupon yield.
  • Bond prices fluctuate inversely to interest rates.

How do bonds work? ›

Bonds are an investment product where you agree to lend your money to a government or company at an agreed interest rate for a certain amount of time. In return, the government or company agrees to pay you interest for a certain amount of time in addition to the original face value of the bond.

What is an example of a bond? ›

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. Like any investment, bonds have pros and cons.

How do bonds return money? ›

How bonds generate income. As we discussed in Topic 1 of this series, governments and corporations issue bonds when they need to raise money. In return for buying the bonds, the investor – or bondholder– receives periodic interest payments known as coupons.

How can bonds make you money? ›

In return for buying the bonds, the investor – or bondholder– receives periodic interest payments known as coupons. The coupon payments, which may be made quarterly, twice yearly or annually, are expected to provide regular, predictable income to the investor..

What are the disadvantages of bonds? ›

Cons
  • Historically, bonds have provided lower long-term returns than stocks.
  • Bond prices fall when interest rates go up. Long-term bonds, especially, suffer from price fluctuations as interest rates rise and fall.

Are investment bonds a good idea? ›

An investment bond gives you the potential for medium to long-term growth on your money, over 5-10 years or more, along with fund management expertise. You also get access to a mixture of funds, which are looked after by professional investment managers.

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