Investing in Bonds

A bond is a financial instrument that represents a debt held by the owner of the bond. When purchasing a bond, an individual essentially agrees to lend a certain amount of money to the bond issuer, such as a company or a government, in exchange for receiving a defined amount of interest from the bond issuer over the term of the bond. Governments or companies issue bonds in order to raise funds for a variety of purposes. Bonds are typically considered relatively low-risk investments, in large part because they are issued by bodies such as governments; however, this low risk typically results in a correspondingly low rate of return. Popular varieties of bonds in the United States include US treasury bonds, savings bonds, and corporate bonds. Like other financial instruments such as stocks, bonds may be traded on the secondary market, and they form the basis of a derivative instrument known as "bond futures."

Background

Like many other financial instruments, bonds have long been issued, held, and traded. In medieval Europe, for example, various countries and city-states issued bonds in order to fund expansion or protection of their territories. In the United States, bonds became important in the early twentieth century when the federal government issued instruments known as "war bonds." War bonds were sold to individuals as well as banks and other financial institutions in order to raise funds to pay for military expenses in World War II. In the early twenty-first century, the US Department of the Treasury issues bonds known as treasury bonds, which are long-term investments with prices and interest rates determined by prospective bond-holders’ bids. They may be purchased by individual investors or larger institutions. Another major type of bond issued by the US government is the savings bond. Introduced in 1935 in an effort to involve the US population in the funding of the nation’s government, savings bonds existed in various forms over the subsequent decades. In 2024, two types of savings bonds existed—Series EE bonds and Series I bonds. Municipal governments and some corporations in the United States will issue bonds to raise money. Corporate bonds represent one of the largest portions of the bond market in the United States.

Financial instruments are typically divided into the categories of equity instruments, which represent ownership of something, and debt instruments, which represent a debt held by the holder of the instrument. Bonds, which effectively represent debts owed by the government or corporation to the bond holder, fall into the latter category. When an individual purchases a bond, he or she agrees to lend the bond issuer a specific sum of money in exchange for interest payments that are to be received in accordance with a set schedule. The investor thus receives income from the investment, either on a steady, recurring basis or in a lump sum when the bond is redeemed.

Like many financial instruments, bonds are available directly from the issuing bodies and through a secondary market. In the secondary market, individuals and institutions trade bonds as the values of the bonds fluctuate in accordance with interest rates. For example, if a bond offers an interest rate significantly higher than the currently offered rate, that bond will typically increase in value as prospective buyers become willing to pay more for it. Bonds also serve as the basis for bond futures, derivative instruments that give investors the right to buy or sell a particular bond at a specific price on or by a set date in the future. By buying and selling bond futures, investors are able to speculate on market changes as well as the value of the underlying securities.

Overview

Like all financial instruments, bonds have various advantages and disadvantages. As relatively low-risk investments, they typically offer low rates of return when compared to investment vehicles such as stocks. However, bonds—particularly government bonds—are often considered an important part of a conservative investment portfolio, and the interest one earns can at times serve to protect one’s funds against inflation.

Treasury bonds are one of the major varieties of bonds offered by the US government. Treasury bonds were formerly issued as paper documents but as of 2015 were available only in electronic form. They are issued in multiples of one hundred dollars and are sold for face value for a term of thirty years, after which they will no longer accrue interest. The process of purchasing treasury bonds is based on a bidding system. When a prospective buyer places a noncompetitive bid, he or she bids on bonds with interest rates determined at auction. When placing a competitive bid, the prospective buyer selects the interest yield he or she wants, although he or she may not be successful in obtaining a bond with that yield. Interest that is accrued is paid to the bond holder every six months, and he or she receives the face value of the bond when the bond is redeemed.

Savings bonds are another form of bond issued by the US government. Intended to be purchased primarily by individual investors, they are issued in relatively small denominations and, like all bonds, represent a debt held by the bond holder. Savings bonds may be purchased by any US citizen, permanent resident, or civilian employee who is over the age of eighteen and has a Social Security number. Individuals under the age of eighteen may own but not purchase them. Savings bonds are typically purchased for face value, although some were historically sold for half that amount. After being purchased, savings bonds begin to accrue interest in accordance with their respective interest rates. Accrued interest is typically paid out in a lump sum when the bond is redeemed. All savings bonds have a maturity date after which they will cease to accrue interest. Typically, the bond holder must hold the bond for a minimum period of time. After that date, however, the bond may be redeemed at any point, regardless of the maturity date. Although once available in paper form from the government and institutions such as banks, these were discontinued on January 1, 2025, and since, savings bonds are only available in electronic form.

Corporate bonds are similar to government bonds in that they represent a debt owed by the bond issuer to the bond holder; however, the issuer in such cases is a company rather than a federal or municipal government. Money raised by selling corporate bonds are often used to fund new business ventures, research, or the purchase of equipment as well as various other business expenses. Corporate bonds are generally considered somewhat riskier than their government counterparts because a company will only continue to pay interest to its bond holders if the company stays in business. As such, a company’s financial health is of great importance to anyone who is considering purchasing corporate bonds, and bonds are rated based on the creditworthiness of the issuing corporations. Corporate bonds may be secured or unsecured. Secured bonds are backed by collateral such as tangible or financial assets that bond holders may attempt to claim if the company defaults on its bonds. Unsecured bonds do not provide for a financial recourse for bond holders.

Because corporate bonds are issued by a wide variety of companies, the terms of such bonds are correspondingly variable. Specific terms such as prices, maturity dates, interest rates, and interest payment schedules differ based on numerous factors, including the specific financial needs of the company.

Bibliography

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