What is a bond, and how does lending money to an issuer actually work?

What is a bond, in plain words?#

The SEC's investor education site describes a bond as a debt security, similar to an IOU, that borrowers issue to raise money from investors willing to lend it for a certain amount of time^[1]. When you buy a bond, you are the lender. The government, city or company that sold it is the issuer, and it now owes you money.

In return, the issuer promises to pay a specified rate of interest during the life of the bond and to repay the principal — also called face value or par value — when the bond matures, or comes due^[1]. FINRA, the U.S. broker-dealer regulator, puts it the same way: the borrower agrees to pay interest in exchange for the capital raised^[2].

That is the whole idea. A stock makes you a part-owner of a company and its future profits — see what a stock is. A bond makes you a creditor with a contract: a fixed list of payments, on fixed dates, as long as the issuer can pay.

What do the coupon, maturity and face value mean?#

Three numbers describe a plain bond. The face value is the amount the issuer repays at the end. The coupon is the interest payment; FINRA notes it is usually paid twice a year^[2]. The maturity date is set when the bond is issued, and on that date the borrower pays the final interest payment plus the face value^[2].

FINRA also groups bonds by how long they last: one to three years is generally short-term, four to 10 years is intermediate-term, and more than 10 years is long-term^[2]. Our glossary has one-page definitions of coupon, maturity and principal.

Who issues bonds, and how are they different?#

FINRA lists issuers ranging from the U.S. government, cities and corporations to international bodies^[2]. This page focuses on three common U.S. families.

Treasury securities — bills, notes and bonds — are debt obligations of the U.S. Department of the Treasury and are backed by the full faith and credit of the U.S. government^[3]. Our page on Treasury bills, notes and bonds explains the differences.

Municipal bonds are issued by states, cities, counties and other governmental entities to pay for day-to-day obligations or for projects such as schools, highways or sewer systems^[4]. General obligation bonds are backed by the issuer's power to tax, while revenue bonds are backed by income from a specific project, such as highway tolls^[4].

Corporate bonds are loans to companies. Investor.gov notes that non-investment-grade corporate bonds, also called high-yield or speculative bonds, generally offer higher interest rates to compensate investors for greater risk^[5]. How agencies grade that risk is covered in bond credit ratings explained.

How can you lose money on a bond?#

A bond's promise is only as good as the borrower and the timing. SEC and FINRA investor materials describe several risks every bond buyer should know:

• Credit risk — the issuer may fail to make interest or principal payments on time and default^[6].
• Interest rate risk — when market rates rise, prices of fixed-rate bonds fall^[7].
• Inflation risk — inflation reduces purchasing power, a risk for investors receiving a fixed rate of interest^[8]; see how inflation affects investments.
• Liquidity risk — liquidity is the ability to sell a bond for cash when you choose^[6]; bonds that trade only sporadically tend to have fewer potential buyers^[9].
• Call risk — some bonds give the issuer the right to buy them back before the maturity date, known as calling the bond^[6], so the interest you expected stops early.

What happens if you sell a bond before it matures?#

You do not have to keep a bond until maturity. FINRA explains that bonds can be bought when they are issued (the primary market) and held until maturity, or traded through a broker-dealer on the secondary market^[2]. The catch is the price.

Investor.gov puts it plainly: if a bond is held to maturity the investor receives the face value plus interest, but if it is sold before maturity it may be worth more or less than the face value^[8]. If interest rates have risen since you bought it, you may have to sell at a discount below par; if rates have fallen, you may be able to sell at a premium^[11]. Our note on why bond prices fall when rates rise walks through the arithmetic.

Trading also has a cost. When a brokerage firm sells you a bond from its own inventory, it may mark up the price above what it paid^[2]. Ask what you are paying before you trade.

Where do bonds fit for a beginner?#

A plain bond's payments are written down in advance, which makes its income predictable as long as the issuer keeps paying. That does not make it risk-free: the risks above are real, and the SEC notes that the longer a bond's maturity, the greater the risk that its value is affected by changing interest rates before maturity^[7]. A bond's yield is the return you earn given the price you pay; the SEC calls yield to maturity a widely used measure to compare bonds^[12]. See bond yield explained.

You can also own bonds through a fund instead of one bond at a time. FINRA defines a bond fund as a mutual fund or exchange-traded fund that invests in bonds^[2]. The trade-offs are covered in bond funds vs individual bonds.

What mistakes do beginners make?#

1. Thinking "bond" means "cannot lose money"

   A bond can lose value if rates rise and you sell early, and the issuer can default. Read the issuer's credit rating and the maturity before you buy.

2. Comparing bonds by coupon alone

   Two bonds with the same coupon can offer different returns if one trades below face value and the other above it. Compare yields, not just coupons.

3. Ignoring call features

   A callable bond can be bought back by the issuer before its maturity date^[6]. Check the call terms in the bond's documents so the income you expect does not stop sooner than planned.

4. Overlooking trading costs

   Investor.gov notes that brokers typically do not list their markdowns separately on the confirmation statement^[11]. Ask the broker for the cost before you buy or sell.