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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  • 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 are issued by governments and corporations when they want to raise money. By buying a bond, you're giving the issuer a loan, and they agree to pay you back the face value of the loan on a specific date, and to pay you periodic interest payments along the way, usually twice a year.

How exactly does a bond 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.

How do bonds work for beginners? ›

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.

Is buying bonds a good idea? ›

High-quality bond investments remain attractive. With yields on investment-grade-rated1 bonds still near 15-year highs,2 we believe investors should continue to consider intermediate- and longer-term bonds to lock in those high yields.

How do you make money from a bond? ›

There are two ways to make money on bonds: through interest payments and selling a bond for more than you paid. With most bonds, you'll get regular interest payments while you hold the bond. Most bonds have a fixed interest rate. Or, a fee you get to lend it.…

Do bonds pay you back? ›

For example, if a company wants to build a new plant, it may issue bonds and pay a stated rate of interest to investors until the bond matures. The company also repays the original principal. Unlike buying stock in a company, buying a corporate bond does not give you ownership in the company.

Why do people buy bonds? ›

Investors buy bonds because: They provide a predictable income stream. Typically, bonds pay interest on a regular schedule, such as every six months. If the bonds are held to maturity, bondholders get back the entire principal, so bonds are a way to preserve capital while investing.

Are bonds taxable? ›

Interest from corporate bonds is generally taxable at both the federal and state levels. Interest from Treasuries is generally taxable at the federal level, but not at the state level.

What is the safest bond to invest in? ›

Treasuries are generally considered"risk-free" since the federal government guarantees them and has never (yet) defaulted. These government bonds are often best for investors seeking a safe haven for their money, particularly during volatile market periods. They offer high liquidity due to an active secondary market.

Why don't people buy bonds? ›

Holding bond funds for shorter periods than that opens you to the risk of further, short-term gyrations in your fund's value, without sufficient time for recovery. And if you buy longer-term individual bonds and have to sell them, you risk the kinds of losses that investors have been experiencing lately.

Do bonds pay interest monthly? ›

How often do the bonds for sale today earn interest? Both EE and I savings bonds earn interest monthly. Interest is compounded semiannually, meaning that every 6 months we apply the bond's interest rate to a new principal value.

What is the semiannual interest payment on a $1000 bond with a 7% coupon rate? ›

For example, a $1,000 bond with a coupon of 7% pays $70 a year. Typically these interest payments will be semiannual, meaning the investor will receive $35 twice a year.

How does bond work in US for jail? ›

Bail is the money a defendant must pay in order to get out of jail. A bond is posted on a defendant's behalf, usually by a bail bond company, to secure his or her release. Defendants with pending warrants are usually not eligible for bail.

Who gets the money from a bond? ›

Bonds are among a number of investments known as fixed-income securities. They are debt obligations, meaning that the investor loans a sum of money (the principal) to a company or a government for a set period of time, and in return receives a series of interest payments (the yield).

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