facebook twitter instagram linkedin google youtube vimeo tumblr yelp rss email podcast phone blog search brokercheck brokercheck Play Pause
The basics of bonds: what they are, how they work, and how to use them in retirement planning Thumbnail

The basics of bonds: what they are, how they work, and how to use them in retirement planning

I receive a lot of questions about bonds. I’m going to try my best to write a summary of the topic here. I could easily write multiple months’ worth of articles about all the intricacies of bonds. However, for now, I want to just write a basic-to-intermediate level overview of them. And then perhaps in the future I might dig deeper into different subtopics about bonds.


Basic features and functions of bonds

There are lots of different varieties of bonds. But for sake of this article, I’m going to try to stick to the most common and most straightforward type of bond; one that pays a fixed rate of interest and has a known maturity date. And unless otherwise mentioned, I’ll be talking about individual bonds, not bond funds, where a bond fund is just a mutual fund or Exchange Traded Fund (“ETF”) whose underlying investments are a collection of individual bonds.

In its most basic form, a bond is a loan to the issuer of the bond. The issuer could be a federal government or entity like the U.S. Department of Treasury, it could be a state or local municipality like the state of New Jersey or the City of Chicago, or it could be a corporation like IBM, Ford, etc.

Issuers issue bonds to borrow money. And they do so where the borrowing will have a known maturity, meaning they agree to repay the loan when the bond matures. For example, the U.S. government might borrow $10,000,000,000 for 10 years via issuing new 10-year maturity bonds. And let’s assume the fixed rate of interest that will be paid on these bonds is 5.00% per year.

While the total amount of borrowing is $10,000,000,000 in this case, it’s not one big single loan from a single lender. Instead, it will be split up into a series of smaller loans, each a bond, where one bond is typically $1,000 of loan. Which means the government will issue $10,000,000,000 / $1,000 = 10,000,000 bonds in this example.

In other words, everyone who buys these newly issued bonds from the government will lend $1,000 per bond to the U.S. Department of Treasury. The government then agrees to pay each bondholder 5.00% of interest every year, which means each bond will pay $1,000 * 5.00% = $50 per year in interest. Technically, interest is paid twice a year, and the rate of interest paid every six months is simply half of the annual interest rate. Which means that instead of getting $50 of interest per bond once per year, bondholders will get 2.50% per bond interest twice a year, or $25 twice a year in this example.

And then at the end of the 10 years when the bond matures, the government will repay the $1,000 loan to the holder of each bond. After the $1,000 is repaid, the bond terminates and ceases to exist; there will be no other payments of any sort between bondholder and the issuer.

To help standardize the terminology around bonds, there are some formal definitions regarding bonds and their features:

  • The initial loan amount and eventual repayment is called the par value or face value of the bond. In our example, that’s the $1,000 per bond that gets repaid to the holder of the bond at the bond’s maturity. It’s also the dollar amount from which the annual interest amount is calculated
  • The interest is also called the bond’s coupon. Meaning you could also say the 5.00% annual interest rate is also the bond’s coupon rate. Similarly, the $50 of annual interest payments could also be referred to as the bond’s coupon payments
  • The end date of the bond, when the par value or face value is repaid to the bondholder, is called its maturity date

To keep the examples easy and consistently, I’ll assume herein that all bonds have a $1,000 face value. In reality, some bonds are offered in different sizes, like $10,000 of face value. But $1,000 per bond is the most common.

Also, I’ll assume bonds pay interest semiannually, or twice per year. While semiannual payments are the most common for bonds issued in the U.S., it’s possible a bond could instead pay interest monthly, quarterly or annually. Furthermore, some bonds don’t pay ANY interim interest, and only pay back the face value at maturity. These are called zero coupon bonds, and I’ll touch more on them in a bit.


Another thing to keep in mind with bonds - and this often leads to a lot of confusion and misunderstanding about how bonds function - is that bonds can be bought and sold during their lives. They don’t need to be held until maturity.

In the example I gave above, the assumption was that someone paid $1,000 for a bond when it was first issued. And then they continue to hold the bond all the while to get its coupon payments. And then they will hold it until maturity at which point they will get the $1,000 paid back to them from the issuer. Then the bond terminates and that’s that.

In reality, most people who buy bonds don’t buy them directly from the issuer when they’re first issued. In many/most cases, someone buys a bond after it’s already been issued.

Similarly, people don’t always hold bonds until they mature. Bondholders often sell their bonds prior to maturity. Selling a bond doesn’t mean the bond immediately matures or otherwise goes away. It simply means someone else buys that bond, and therefore becomes the recipient of its remaining future coupon payments and eventual maturity repayment.

Let’s go back to the example of the U.S. Department of Treasury borrowing $10,000,000,000 via newly issued 10-year bonds. When the bonds first come into existence and are sold to the world, this is called the primary market. The initial investors/bond purchasers are the ones who give the money directly to the U.S. Department of Treasury. In that sense, it’s these original bond purchasers who are making the loans to the government. And, in return, the bonds they receive are IOUs evidencing the government’s contractual commitment to pay the holder of each bond $25 of interest every six months, plus pay back the $1,000 of face value at maturity.

However, these initial investors/bond purchasers aren’t required to hold the bonds all the way until they mature. Instead, they can sell them to others who want to buy them. And if/when the original bond purchasers sell the bonds to someone else, that’s then called the secondary market.

When someone buys a bond in the secondary market, the price they pay for the bond will likely be something different than $1,000. This is where things can get tricky, and I’ll get into it more below. However, regardless what price someone pays for the bond in this example, they will nonetheless get $25 of interest every six months, and also get $1,000 from the issuer when the bond matures.

Or, the person who bought the bond in the secondary market can choose to later sell it prior to maturity. At which point, the price they receive from the seller could similarly be more or less than $1,000 for the bond, and it could be more or less than the price they paid when they bought the bond from its original owner. Again, I’ll get into the basics of bond price mechanics in a little bit.

To wrap up this intro section, when buying a bond, you’re buying the right to receive from the bond’s issuer 1) a known amount of interest payments every six months ($25 every six months, in our example) and 2) the bond’s face value at maturity ($1,000, in our example). And if you choose to sell a bond before it matures, you are giving up the right to receive the remaining interest payments and face value repayment at maturity. In place of giving up the right to receive those future payments, you are getting paid from the bond buyer to buy you out of the right to receive those things.


Risks in bonds

Before going more into the different types of bonds and how they can be used, we need to first address the potential risks in investing in bonds. For now, I’ll just reference the risk of holding individual bonds as opposed to bond funds. I’ll talk more about bond funds later in the article.

There are two main risks in owning bonds: credit risk and interest rate risk.

Credit risk is the risk of the bond issuer defaulting on their contractual obligations by not being able to pay you all interest payments and the face value repayment in full and on time. Recall that a bond is ultimately nothing more than the right to receive a stream of known payments from the issuer. In the event the issuer runs into financial difficulties, it’s possible they won’t be able to pay you all their obligations under the bond. Or at least, they might not be able to pay you all obligations on time. Even if they end up paying you in full on all the coupon payments and face value repayment, if they don’t pay you each of those on time, it’s still technically a default.

Interest rate risk is the fact that a bond’s price will fluctuate throughout its life as the market level of interest rates moves around. Which means if you decide to sell a bond before it matures, the price you’ll get for it might be something more or less than its face value. However, if you hold a bond until it matures, the price changes along the way ultimately didn’t matter, as you know you’ll end up getting paid out exactly the face amount at maturity (barring the issuer defaulting). I’ll discuss interest rate risk and the price mechanics of bonds in more detail below.


The above two things are the two main risks involved in owning bonds. However, there are some other potentials risks that could be present, too:

Reinvestment risk is the notion that you know what rate of interest you’re getting on a bond you currently own, but when that bond matures and you go to reinvest the money into a new bond, you don’t know what rate of interest new bonds will pay at the time. Maybe it will be more than what you were getting in your old bond, or maybe it will be less.

Inflation risk arises in most bonds as the rates of interest they pay are fixed, as are their face amounts. Which means the dollar amounts of interest they pay throughout their lives are fixed. The risk is that the interest payments you receive stay static throughout the life of the bond, while inflation will inevitably increase over time. Therefore, you’re losing purchasing power. One potential way to address inflation risk is through buying bonds which incorporate inflation adjustments to their payments, such as Treasury Inflation Protected Securities, or TIPS, as further discussed later.

Call risk is present in bonds that are callable, which means the issuer has the contractual right to buy you out of the bond early, prior to the bond’s maturity. For bonds that are callable, call risk increases as the market level of interest declines. For example, assume you have a bond paying 6.00% interest each year. And further assume interest rates steadily decline to let’s say 2.00%. The issuer could be incentivized to call your bond, and buy you out early, to then instead issue new bonds where they would only have to pay 2.00% interest each year, instead of the 6.00% they were previously paying you and other holders of the called bonds.


Bond issuers and maturities

As I mentioned before, various types of entities can issue bonds as a means to borrow money. The most common forms of borrowers are national or federal governments, state and municipal governments, and corporations.

As a bond buyer, there are different reasons to consider buying bonds from different issuers.

From a credit risk perspective, buying bonds from a highly rated and highly creditworthy entity like the U.S. government is deemed to be the safest. In other words, the risk of the U.S. government defaulting is assumed to be the lowest when compared to other borrowers who aren’t the U.S. government.

Buying bonds from a corporation could be a high or low credit risk. Some corporations are exceptionally financially stable and there is deemed to be minimal risk of them defaulting on any bond obligations. At the other extreme, some corporations are highly speculative and financially risky such that the potential for default is rather high.

State and local governments could be high or low credit risk, depending on how fiscally stable they are.

So why would someone consider buying bonds from the U.S. government vs a corporation vs a state or local government? Generally speaking, it would be due to different risk/reward decisions. Bonds from the U.S. government are deemed to have the lowest credit risk and virtually zero chance of default, so they will generally pay the lowest interest for a given maturity. And bonds from financially weak corporations will tend to pay the highest interest, to entice buyers to buy their bonds and lend them money. But there is no free lunch; there is a much higher risk of those bonds defaulting and the buyer not ultimately receiving all the promised interest payments and face value repayment of the bond.


There are also potentially tax considerations in determining which types of bonds to buy, particularly when buying the bonds in a regular taxable brokerage account as opposed to a tax-qualified account such as an IRA or Roth IRA.

Interest paid on bonds issued by the U.S. government is taxable at the federal level, but tax-free at the state level in all states. Interest paid on bonds from state and municipal issuers is typically tax-free at the federal level and tax-free at the state level in the state where the bond was issued (i.e. a New Jersey resident wouldn’t pay New Jersey income tax on interest from a bond issued by the state of New Jersey, but would have to pay New Jersey income tax on interest from a bond issued by the state of Virginia). And interest paid on bonds issued by corporations is taxable at both the federal and state levels.


Besides determining which issuer of bonds to buy, the other main consideration is which maturity of bonds to buy. Bonds issued in the U.S. normally have maturities ranging from a short as a week, to as long as 30 years. There are potentially bonds with longer maturities, but they’re not very common. For example, there are some bonds that have 100-year maturities. And some bonds are perpetual, meaning they don’t have any maturity!

While this doesn’t always hold true, normally the longer the maturity of a bond, the higher its interest rate will be, and vice versa. As such, a reason to perhaps consider buying a bond of a longer maturity is that it would normally pay a higher rate of interest than a shorter maturity bond.

I’ll talk more about interest rate risk and how interest rates impact bond prices later on. But for now, while we’re on the topic of maturity, I feel the need to say that the longer the maturity of a bond, the more sensitive the bond’s price will be to change in the market level of interest rates. All else equal, the price of a 30-year bond will increase or decrease more than the price of a 1-year bond for a given change in interest rates.


Before moving on, I want to add some more important terminology. Thus far I’ve been generically referring to all bonds as “bonds.” But technically, there are some naming differences based on the bond’s maturities:

  • Bills are bonds whose original maturities are no greater than a year
  • Notes are bonds whose original maturities are greater than a year but no greater than 10 years
  • Bonds are bonds whose original maturities are greater than 10 years

Notes and bonds generally pay recurring interest amounts, typically semiannually like I said before. However, it’s possible for certain notes and/or bonds to be zero coupon bonds, and not pay any interest. Instead, their only payment will be the repayment of the face value at maturity. And bills normally function the same way; there are no interim interest payments, just the repayment of face value at maturity. This is how all U.S. Treasury bills function.

Since there will be no ongoing interest payments from which to get income or return in zero coupon bonds, holders of such bonds make money on them by buying them at a discount to their face value. For example, assume a U.S. Treasury bill has a face value of $1,000. If you were to buy a brand new 1-year Bill today, it would sell for roughly $958. Which means you’d pay $958 to buy it, wouldn’t get any interest payments between now and its maturity, and then you’ll get paid $1,000 from the U.S. Department of Treasury at the bill’s maturity. All said and done, you will have paid $958 and a year later received $1,000. That $42 of gain is roughly a 4.4% return on your $958 purchase. And technically the $42 of “gain” is reported and taxed as interest income, not capital gain, on your tax return.


How bonds can be used

At the risk of oversimplifying things, I view the use cases for bonds as boiling down into three possible categories

  1. Generate known amounts of recurring income
  2. Provide principal protection for a given amount of time to match future cash inflows with known future cash outflows
  3. Provide some relative stability and volatility dampening in the context of a broader investment portfolio that contains more volatile assets such as stocks

Most of you reading this will want to address one or all these three things at some point. And using bonds could potentially be good solutions. That’s not to say bonds are the only solution or are guaranteed to be the best solution. But they are potential solutions nonetheless. Like most things involving investing, different people will want or need to use different instruments for their own unique reasons.

Here is more detail about each of the three categories:

Generate known amounts of recurring income

This is pretty straightforward when you think about the basic mechanics of how a bond functions. Looking at the original example, for every $1,000 of face value bond you buy, you will receive $25 of interest every six months, or $50 every year.

For example, if you want to receive $50,000 per year in income, you could potentially buy one thousand bonds, which would total $1,000,000 of face value. In this case, you know you are going to receive exactly $50,000 per year in interest income for as long as the bond lasts, which is up to the bond’s maturity in 10 years.

The math and analysis are simple here; if you know you want or need $X of income per year, you can back into how many bonds it would take to generate that much annual interest.

There are a few potential drawbacks though. For example, the bonds will eventually mature, at which point the interest will also stop. If you want to continue getting known amounts of interest each year (or, more accurately, each six months), you’ll have to buy new bonds when your original bonds mature. This is where reinvestment risk comes into play. What if the interest rates on new bonds at the time are much lower than the rates you were getting in your matured bonds?

Another potential downside is it could mean tying up a lot of money in buying bonds to get a large enough amount of annual interest to meet your income needs. Again, in this example, if you wanted $50,000 per year in interest income, you’d have to tie up roughly $1,000,000 of your investable money in buying bonds. That is more money than many people have and/or are able to tie up for the sake of getting $50,000 per year in our example.

Another possible drawback is inflation risk. In the example above, I’m assuming you bought a normal nominal bond; one that doesn’t have any sort of inflation increase to its interest or principal payments. However, certain bonds issued by the U.S. Department of Treasury, do incorporate a mechanism to increase with inflation. These are called Treasury Inflation Protected Securities, or TIPS, like I mentioned before.

The percentage rate of interest paid by TIPS will be fixed, but the dollar amount of the bond’s face value will increase over time as inflation increases. Which means the dollar amount of interest payments will increase over time with inflation. As will the eventual repayment the face value at the maturity of the TIPS.

As an example, assume a new 10-year TIPS bond has an annual coupon rate of 2.50%. All else equal, the coupon rate on a TIPS will be smaller than on a comparable maturity nominal Treasury bond, due to the fact that the principal – and therefore interest payments – will increase over time with a TIPS.

Assume the TIPS bond has a $1,000 face value at the inception of the bond. Which means the first annual coupon will initially be 2.50% * $1,000 = $25. But since TIPS pay coupons semiannually like normal bonds due, it would actually be a first semiannual coupon of 1.25% of $1,000, or $12.50.

And then assume inflation is 1.00% before the next semiannual coupon payment. The face value of the TIPS would increase by 1.00%, to $1,010. So then the next semiannual coupon would be $1,010 * 1.25% = $12.63.

This inflation adjustment process happens every six months until the bond matures, at which point the face value that it will pay out to the bondholder will be whatever the inflation-adjusted face amount is at the time, which will be something higher than $1,000.

In case you’re wondering, if there is deflation instead of inflation, the face value of the TIPS will decline. Which means the coupon payments would decline. However, TIPS will never pay out a face value less than $1,000 at maturity. Which means TIPS holders are guaranteed to get back no less than $1,000 when the bond matures, even if there was deflation and their coupon payments decreased throughout the life of the bond.

Provide principal protection for a given amount of time to match future cash inflows with known future cash outflows

Another potential use case for bonds is holding a bond to maturity to match up the timing and amount of face value repayment with a known need for cash you’ll have at the time.

For example, assume you know you’re going to need $300,000 available to you a year from now to use as a downpayment on a house you plan on buying at the time. And you currently have $300,000 of cash sitting in your checking account. You could just let the money sit in your checking account until then. However, by doing so, you’re not getting as much interest as you can elsewhere, and you might also be exceeding FDIC insurance limits for having that much cash at one bank.

Knowing you’re going to need no less than $300,000 available in a year, you’re not going to want to put that money into something that has a risk of principal loss, such as a stock mutual fund. Yes, maybe that stock mutual fund might make that $300,000 grow by 10% or more. But it could also result in you losing 10% or more…

This means you’re likely going to want to put the money into something that will protect your principal during the next year. And you’ll want to ensure you can fully access all $300,000 in a year without any surrender or redemption penalties or restrictions. And you ideally want to try to get as much interest as you can, without sacrificing the principal protection or liquidity/accessibility of the money.

Buying bonds that will mature in one year could be a possible solution. Assuming each bond is $1,000 of face value, you could buy 300 bonds which means you’d get paid out exactly $300,000 at maturity. Plus you’d get whatever interest the bonds would pay between now and then.

Provide some relative stability and volatility dampening in the context of a broader investment portfolio that contains more volatile assets such as stocks

Bonds aren’t risk free, and different types of bonds can be much more volatile than others, for reasons I’ll explain later. But, generally speaking, bonds have lower risk and lower volatility (i.e. less extreme swings in price) than stocks.

With that in mind, bonds can provide a ballast to help reduce or dampen the overall volatility of returns of your portfolio that’s otherwise presumably in riskier and more volatile assets such as stocks.

For example, assume you have a portfolio that’s 60% in stocks and 40% in bonds. And assume it’s a bad year for the stock market and your stocks are collectively down 20%. Let’s assume your bonds are collectively up 2% for the year. This means that your total 60/40 portfolio has a current year-to-date return of (-20% * 60%) + (2% * 40%) = -11%. While it’s not ideal to have your portfolio be down 11%, it’s at least better than if you were invested in all stocks and would have then been down 20%.

Conversely, assume stocks are up 20% for the year. And your bonds are still up the same 2%. Your total portfolio’s year-to-date return would now be (20% * 60%) + (2% * 40%) = +13%. You might be upset that you weren’t invested just in stocks because you would have been up 20% instead of only 13%. However, you can’t have your cake and eat it too; if you want to take on the higher potential reward of being just in stocks, you have to also take on the higher potential risk. Which many in or near retirement aren’t willing or able to do.

In this context, having some bonds in your portfolio can mute or dampen the extremity of the swings in portfolio value you would have if you were invested in only stocks. Sometimes this dampening will work in your favor, such as the above example where your loss was smaller than it would have been if you were all stocks. And sometimes it will work against you, such as leading to a smaller gain than you’d otherwise have if you were in all stocks. For better or worse, this is the price of diversification and reducing portfolio risk.


Bond price changes

This part can get technical and mathy, but I’ll try my best to keep it as digestible as possible, while still providing enough context to understand the reasons why a bond’s price can fluctuate over time.

Ultimately, a bond’s price is nothing more than a math equation. Unlike the price of a stock and/or the change in the price of a stock, which is ultimately supply and demand auction pricing, bonds have more of a range bound correct price that the market collectively agrees on using some basic math principles.

Stock prices can do wild and often inexplicable things. Ultimately, the price of a stock is whatever someone is willing to pay for it. Like I said above, it’s all just one big auction, where supply and demand drive the price. And the underlying reasons for the supply and/or demand don’t need to be rational. In fact, they’re often not rational. And this is because stocks don’t have a finite end date, and the economics and cash flow from stocks are much more unknown. After all, what exactly is it worth to own a super small slice of a huge publicly traded company??? You might think it’s worth $X, but I might think it’s worth $Y. You might think the company’s future net income is going to be really high, while I might think it’s going to be much lower. And neither of us are necessarily right or wrong, as neither of us can know the future.

With a bond, however, all potential future economics are known in advance. We know exactly when a bond will pay cash flows (i.e. coupon payments and face value repayment), and we know the exact dollar amount those cash flows will be.

With this in mind, the price of a bond is simply just the sum of each of its future cash flows to be received. However, receiving a dollar in the future is not the same as receiving a dollar today. This is because there is a “time value” to money, since money can earn interest.

For example, if you have one hundred dollars today, you can put that money into a one-year bank CD and get a guaranteed interest rate of 3.5%, let’s say. That means that in one year’s time when the CD matures, the bank will pay you back your $100.00 plus $3.50 of interest. Which means you’ll get paid a total of $103.50.

Given the fact we know we could get 3.5% interest for one year, we know the “time value” of $100.00 today is such that it would be worth $103.50 in one year. And we can view this relationship in reverse, too: $103.50 one year from now is worth $100.00 today.

To take this a step further, assume we could get 4.0% interest in a two-year CD. Which means if we put $100.00 into a two-year CD today, it would be worth $108.16 in two years (i.e. two years of compounding interest at 4.0% each year). We can again view this in reverse; $108.16 in two years is worth $100.00 today.

In other words, if you had the chance to receive $108.16 in two years, what would you be willing to pay for it today??? Using our basic example here, the answer would be $100.00. Obviously, you’d be plenty happy to pay LESS THAN $100.00 today to receive $108.16 in two years.  But the person paying you the $108.16 in two years wouldn’t be interested in receiving any less than $100.00 today. Because if we all know the rate of interest that someone can get for investing money for two years is 4.0%, then the “time value” of what money is worth today vs two years from now is nothing more than a basic compound interest math equation like I just showed above.


Anyway, we can use time value of money math to figure out what the present-day value should be of all of the future cash flows of a bond. Just like above, we can use the time value calculation in reverse to take a known future amount of money and translate it to a present-day value. And when figuring out the present-day price of a bond, it’s ultimately nothing more than doing the present-day time value calculation of every remaining coupon payment and the maturity face value repayment, and then summing up all those present-day values. Easy, right?!

I’m reluctant to get into showing formulas here and going too far down the math rabbit hole. Maybe I’ll get more into that in a future article. For now, after understanding the basics of time value of money math, here a few main things to know about what impacts a bond’s price:

  • If the market level of interest rates rises, the price of an existing bond will decline. And vice versa.
  • The longer the remaining time to maturity of a bond, the more its price will change because of a given change in the market level of interest rates. For example, the price of 30-year bond will move much more than the price of a 1-year bond from a given change in interest rates.
  • The extent of a bond’s price change sensitivity relative to underlying changes in interest rates is known as the bond’s duration. Technically it’s a measure of duration called modified duration, as opposed to another measure called Macaulay duration. A bond’s duration represents the approximate percentage change in price that will result from a 1.00% change in the market level of interest rates. For example, assume you buy a new 10-year bond when the market level of interest rates is 5.00%. The bond will have a duration of roughly 7.7. Which means if the market level of interest rates for 10-year bonds increases from 5.00% to 6.00%, your bond will decrease in price by approximately 7.7%. And vice versa if the market level of interest rates were to decrease from 5.00% to 4.00%; your bond will increase in price by roughly 7.7%.
  • If you hold a bond until it matures, you know exactly what you will get, and when. You know the timing and dollar amounts of all remaining coupon payments, and you know the timing and dollar amount of the face value repayment at maturity. As such, even if the bond’s price does move around while you own it before the bond matures, that ultimately doesn’t matter. So long as you hold the bond until it matures and don’t sell it before then, you know exactly what you’ll get, and when. Which means the changes in price along the way were ultimately irrelevant.
  • Piggy backing off the point above, if you do want or need to sell a bond before it matures, you have no way of knowing in advance what the price will be when you go to sell it. Like I mentioned above, if interest rates increase, the price of your bond will decline. And vice versa.

Again, there is a lot more to potentially dig into beyond what I covered above. But in the interest of trying to not let this article get too long, the important things to know about bond prices are what I just bulleted above.


And I want to share one more way of thinking about why bond prices change as the market level of interest rates change. And this way is more intuitive to understand. However, while this explanation is more convenient and easy to digest, the actual reason a bond’s price changes is due to the pure time value of money math principles mentioned above.

Anyway, this other explanation goes as follows: if you own a bond currently paying a 5.00% coupon and the market level of interest rates increases such that new bonds of similar remaining maturities to your bond are now paying 6.00% coupons, why would anyone want to buy your bond and get 1.00% less in coupons than they otherwise could? Especially since both bonds will pay the same $1,000 face value at maturity. It would be a sucker bet to buy the bond paying only 5.00%, all else equal.

To help account for the fact that your bond will continue to pay less in coupons than newer bonds of similar remaining maturities would, you’d have to sell your bond for a price lower than $1,000. As such, by buying your bond at a discount to its face value, the buyer will make some additional economics on owning your bond from buying it for something less than $1,000 and ultimately getting back $1,000 at maturity. This additional gain will help supplement the otherwise lower ongoing coupon yield they will receive compared to newer bonds. So then when they combine the gain on the price of the bond and the total amount of coupons to be paid over the bond’s life, the total yield or return of the bond will end up at roughly 6.00%; comparable to what the person could have gotten had they bought a new bond paying 6.00% coupon.

And vice versa; assume the market level of interest rates declines to 4.00% and you have a bond paying a 5.00% coupon. Everyone will want your bond instead of newer bonds, because your bond is paying more in coupon payments than other newer bonds in the market. Which means your bond will sell for a premium if you were to sell it before maturity; someone will pay more than $1,000 to buy it, to then only get $1,000 paid out to them at maturity. While they will be losing a bit on the price of the bond, they will be getting ongoing coupon payments that are higher than what new bonds would pay. So then when factoring in the little bit of loss they’ll have on the price of the bond with the higher than market level of coupon payments of 5.00%, the ultimate yield or return they will realize on holding the bond to maturity will end up being comparable to the roughly 4.00% they could have gotten from just buying a new bond that pays 4.00% coupon.


Bonds vs bond funds

When investing in bonds, you can choose to do so by buying an individual bond, multiple individual bonds, or by buying a fund that invests in bonds. There are potential pros and cons to each, so neither is necessarily better, per se. It all depends on what you’re trying to accomplish, how much you’re trying to streamline and simplify your investment management process, how much risk you’re willing and able to take in your bond positions, etc.

One of the main pros of buying an individual bond is that you know exactly what you’re going to receive, and when, assuming you hold it maturity (assuming the issuer doesn’t default along the way). So if you know you want to get exactly $X of interest each year and then receive $Y of face value repayment at a known maturity date, buying an individual bond could be the right fit.

But recall that if you sell a bond prior to maturity, you might get something more or less than the face value of the bond when you sell it; it all depends how interest rates have moved since you bought the bond. But if your hold the bond until maturity, the price changes along the way will not have mattered, as you will have received exactly the bond’s face value back at maturity.

If you want to have different bonds maturity at different dates – such as building a ladder of maturity dates and amounts - you can do so by buying a collection of individual bonds. However, the more bonds you buy, the more you have to stay on top of knowing when each matures so you know you’ll then have to do something with that money, such as reinvest it. And if you buy bonds that are callable by the issuer, you run the risk of them calling your bond and essentially cashing you out earlier than the original maturity you were expecting. For what it’s worth U.S. Treasury bonds generally aren’t callable. But corporate bonds typically are.

Another potential downside of individual bonds is credit risk, particularly when investing in bonds not from a highly rated issuer like the U.S. government. For example, if you buy one bond and it’s from a corporation of questionable creditworthiness, there is a nontrivial chance it might default and you won’t end up getting all of the interest payments and/or face value repayment you were expecting.


All said and done, owning individual bonds can help achieve each of the three potential uses cases for bonds I mentioned above (recurring income, known principal cash flows, and portfolio volatility dampening)


The main benefits of bond funds are ease and diversification. Assume you want to invest in corporate bonds to try to get some higher interest than what you could get from just investing in U.S. Treasury bonds. However, you don’t want to have too much concentration to any particular issuer from buying just one or two bonds. And you don’t want to mess around researching and buying 50 different bonds to diversify your credit exposure. You could consider buying a bond fund that invests in a diversified pool of hundreds of corporate bonds from different issuers. That way, you’re not too exposed to the credit risk of any one corporation.

And bond funds could have a bit of ease factor to them in that you could buy the fund once, and not need to worry about having to track the maturity of your bonds and reinvest the money into a new bond every time an existing bond matures.

Like funds that invest in stocks, most bond funds don’t have a maturity or end date. Most bond funds invest in hundreds or thousands of individual bonds. And those individual bonds inside the bond fund portfolio will obviously mature over time. But the manager of the fund will continually replenish the pot of bonds inside the fund, so there are basically always some bonds coming and some bonds going. You, as the bond fund investor, don’t need to worry about the constant process of having bonds mature and having to reinvest the proceeds.

Since bond funds are made up of a collection of bonds, the fund will pass through to you the economics from the underlying bonds. Which means it will pass through to you the interest from the underlying bonds, and any realization of gains or losses if any bonds inside the fund are sold (or in the case of an ETF as opposed to an actively managed mutual fund, you likely won’t have any capital gains passed through to you. But that’s a whole other can of worms and detailed explanation I’ll save for another day).

While the main benefit of a bond fund is ease and diversification, the main downside is that most bond funds are evergreen and don’t have a maturity. Which means there will be no known maturity date where you know you’re going to get paid out exactly $X like you would if you owned an individual bond to maturity. As such, most bond funds have interest rate risk in that you’re going to need to eventually sell some or all of your bond fund position. And when you do, you have no idea what the price the fund will be at the time. Like I mentioned before, if the market level of interest rates rise, the price of bonds – and bond funds – will decline. And vice versa. Which means most bond funds don’t provide any sort of principal protection.

You can help to minimize the interest rate risk of bond funds by only buying bond funds that invest in short-term maturity bonds. Which means the interest rate risk/price change risk will be minimal. But the downside is you will likely receive less ongoing interest than you would if you bought a fund that invested in longer-term maturity bonds. As with most investing decisions, there is another risk/reward tradeoff you need to make.


One final comment about bond funds is to let you know there is a relatively new form of bond fund called a bullet ETFs. These are bond funds, in ETF form, where the fund DOES have a known maturity. This helps minimize and manage the interest rate risk you’d otherwise have in holding a bond fund that doesn’t have a maturity.

With a bullet ETF, all of the bonds held by the fund mature in the same year. For example, you can buy a bullet ETF where all of the bonds mature in 2030. This way, you kind of get the best of both worlds; 1) the principal is more or less protected like it is in an individual bond IF you hold the fund until it matures as you know roughly how much face value you’re going to get paid out at the time, and 2) it offers a lot of diversity in the sense that you can buy just one fund yet get the underlying exposure to hundreds of individual bonds.

There are currently a few providers of bullet ETFs, such as Invesco and iShares (which is Blackrock). And each offers a few different types of underlying issuers, such as just U.S. nominal Treasuries, just TIPS, just investment grade corporate bonds, just municipal bonds, etc. And each offers varying years of maturities, so you can pick and choose the length of maturity you want in your fund.


Bond funds can also help achieve each of the three potential uses cases for bonds I mentioned above (recurring income, known principal cash flows, and portfolio volatility dampening). While all bond funds can provide recurring income and portfolio volatility dampening, not all bond funds provide known principal cash flows. For example, bullet ETFs can be used to more or less get principal protection and a known face value payment if held to the fund’s maturity, but most other bond funds (i.e. those without a maturity) generally cannot.


In closing

There is A LOT more nitty gritty and context I wanted to write, but I’m trying to not have the article’s length get too carried away. With that said, this article isn’t a truly comprehensive discussion of bonds and bond investing. Frankly, it really only scratches the surface about bonds. But hopefully it’s at least a good starting point from which you can build your knowledge and ask additional questions as they may pertain to you and your bond investing goals and objective.

And if you want to see some more detail, including visual calculations and explanations of things like interest rate risk, you can check out a video I made in 2021 called Bonds, Bond Prices, and Bond Yields, which is a replay from a live video I did at the time. It’s a little over an hour, but it’s full of good info and explanations.