Become a better investor
Lesson in Course: Bonds (beginner, 3min )
James Bond is an icon, but what are bonds? Are there different types?
Bonds are simply loans or debt. For a refresher on how debt works, check out the lesson about borrowing money.
However, we are on the other side of the transaction when we invest in bonds, meaning we are lending money rather than borrowing it. This means that we receive interest payments for the money we loaned, called coupon payments.
A coupon or coupon payment is the annual interest rate paid on a bond, expressed as a percentage of the face value (value loaned) paid from the issue date until maturity.
Similar to how we borrow money to pay for expensive things such as a car or a house, governments and companies will issue bonds to fund projects or significant expenses. Government bonds fall into two major categories:
Treasury bonds are bonds issued by the federal government. The federal government issues bonds to fund national infrastructure projects and other government spending needs as an alternative to raising money through taxes. We consider these bonds the safest and least risky because they are considered more financially secure and are less likely to default on their payments.
Municipal bonds, also known as Muni bonds, are issued by local governments and typically fund public projects such as roads, schools, airports and seaports, and infrastructure-related repairs. These bonds usually have higher interest rates because local governments are slightly less financially secure and more likely to default. The higher interest rate is compensation for taking on somewhat more risk.
Suppose a company has to raise additional cash to fund a significant project or pay for some extra expenses. They will typically finance it using debt by issuing bonds rather than selling equity (ownership in the company) by issuing stock. Overall, we consider corporate bonds riskier than government bonds because companies have higher default risk and are more likely to go bankrupt.
We place these bonds into two major categories based on their creditworthiness. Investment-grade bonds are generally at higher risk than government bonds but represent the most financially stable companies. High yield bonds, also known as junk bonds, are riskier corporate bonds and usually have the highest interest rates.
Bonds are generally less risky than stocks making them a great way of diversifying our portfolio. We can use them to help preserve the money we have while also generating income from coupon payments.