Bonds are a key part of a diversified investment portfolio. In this post we’ll talk about what a bond is, how it works and the role it plays in your portfolio.
A bond is a fixed income security, which means it is a security that has a fixed duration and a fixed interest rate. Fixed income is an asset class. Asset classes are simply a way to group the types of investments in our portfolio. The other 2 asset classes that we’ll discuss in our posts are Equity and Cash. You can read more in the post on Equity, Fixed income & Cash .
What is a Bond?
Let’s talk about what exactly a bond is. Most of us are familiar with stocks. If not, check out our post here. When you buy a stock, you are taking an ownership stake in a company. A bond is very different. When you purchase a bond, you are essentially loaning capital to a corporation or government entity. That entity is going to use the capital to finance its business activities – hire employees, buy buildings, build roads, etc. In return for loaning your capital (money) to the corporation or government entity, you will receive a fixed rate of interest for a fixed period of time. When that time period is up, you will receive your capital investment back in full, and interest payments will cease.
Bond Example
Let’s take an example. I want some fixed income exposure in my portfolio and I go out and buy a new issue Home Depot corporate bond with a par value of $1,000, a coupon of 5%, and a maturity date of 2/1/2029. Home Depot is the issuer. Home Depot issues the bond to raise capital to grow its business, pay employees, or to finance other business activities. The par value, or face value, is the cost of the bond. Most bonds have a par value of $1,000. Home Depot likely needs a lot more than $1,000 so it will issue lots of these bonds at once. We’re just buying one in this example.
The coupon of 5% tells us that Home Depot will pay the bond-holder (us) 5% of the par value per year. That’s a cool 50 bucks a year for us. The maturity date of 2/1/2029 tells us it is a 5 year bond and we’ll get interest payments of $50 per year through 2/1/2029, at which time our $1,000 will be returned and interest payments will cease.
Bonds will also specify the frequency of the interest payments. Typically they are annually, semi-annually, or quarterly. Regardless of how often payments are made, the total for the year will be 5%, or $50 for each bond holder.
Government Bonds
I mentioned that bonds are issued by corporations or government entities. The US government issues many different types of bonds. There are Treasury Bonds, Treasury Bills, Treasury Notes, I Bonds, Series EE Bonds, and others. We’ll talk more about these in an upcoming post. But like corporations, the US government issues bonds (debt) to finance many of its programs.
State and Local governments issue bonds as well. Your town may issue a bond to fund the building of a bridge.
Taxes on Bond Interest
Whether the issuer is a corporation, US Government, or a state or local government, the bonds work the same way our Home Depot bond does. A key difference though is taxation. Often times there are tax advantages to government bonds. Treasuries are often exempt from state tax, though you will still need to pay federal tax on the interest earned. State and local bonds – sometimes referred to as municipal bonds are sometimes exempt from federal taxes on interest earned. If you reside in the state that issues the debt, you may also be exempt from state tax on the interest you receive. Be sure to look closely at the bond and do your own research to ensure you understand your tax liability on the interest earned.
Selling Bonds
Back to our Home Depot bond. We’re happy with our bond purchase and the $50 yearly dividend. However, in an unexpected turn of events, inflation remains stubborn and the fed continues to raise rates. In mid-2025, we have a large unplanned car expense and we need to raise some cash, so we decide to sell our bond. We open a sell order at our brokerage with a price of $1,000. No offers – How come?
The reason no one is interested is because rates have gone up. A similar Home Depot bond is now earning 7% interest. Picture yourself as a buyer, on the other side of this transaction. You can have a bond that pays 5% or a bond that pays 7%, which would you buy? At 7%, you are getting $70 per year in interest, compared to the $50 you would get at 5% interest. So how do we sell our bond?
The difference in annual interest is (70-50=20) $20. There are 4 years remaining til the 2029 expiration, so over those 4 years the original 5% bond will pay (4×20=80) $80 less in interest. So in order to sell your 5% bond, you will need to discount the selling price to $920 to compensate the buyer for the lower interest payments.
That’s Interest Rate Risk
This is a very important concept. This is called interest rate risk. If you hold a bond to maturity, you will get your original investment back1. However, if you sell the bond on the secondary market2 you will need to accept the price that the market is willing to pay. That price will be greater (trading at a premium) or less (trading at a discount) to face value, depending on the current interest rate environment. In our example here, rates have gone up so a bond with a lower rate than market is less attractive and trades at a discount. If rates go down, your bond will be more attractive to investors because its rate is higher than market so investors will pay a premium.
Default Risk
Another type of risk that bond investors need to be aware of is called default risk. Default risk is the risk that the bond issuer will not be able to fulfill their obligations in paying either the interest, principal, or both. The issuer may offer the bond in good faith, but then due to unforeseen circumstances, they do not have the cash available to pay bond holders.
One important note regarding default risk: Bond debt is typically more senior to other forms of debt. This means, for example, in a bankruptcy, bond holders would be paid back before any equity investors. Bond holders may not be paid back in full, but they have a more senior claim on any remaining capital.
Bond Ratings
Don’t let this discourage you, there are ways to mitigate default risk. There are several independent agencies that analyze each bond issuer’s financial health and assign a rating to the issuer.
Moody’s assigns ratings from Aaa through Ca with Aaa being the best financial health & lowest risk.
Standard and Poor’s and Fitch’s scale goes from AAA through CC.
The financially stronger companies are considered investment grade, while less financially strong companies are considered high yield or junk.
Risk v. Reward
You’ve likely heard the expression the more risk, the more reward. The bond market works on this principle. The lower rated companies will pay you a higher interest rate to buy their bond. There is a higher risk of default so an investor needs to be paid a higher rate to assume that additional default risk. It works the same way when you and I apply for a loan. If you have a higher credit score than me, you can borrow money at a lower interest rate. Because my score is lower, there is a higher default risk with me, so the bank will want to be compensated for taking on that risk. They do this by charging me a higher rate.
As an investor, you may decide to buy some high yield bonds to earn a higher interest rate. You’re taking on more risk, but the additional interest may make it worthwhile.
Diversification
And similar to the discussion on stocks, if you want to mitigate this risk through diversification (owning lots of bonds), a mutual fund or an ETF is a great alternative. A bond fund may follow an index or may be actively managed. It will have a portfolio of bonds with different durations and interest rates.
A solid investment portfolio has a mix of Equity, Fixed Income and Cash. Understanding what bonds are and how they work will help you be confident in adding Fixed Income to your portfolio. As always, let me know what you think and what questions you have.
1 In the event that the issuer defaults, the bond holder may not get all of their investment back.
2 The secondary market is the market where investors buy and sell securities from other investors. The primary market is where an investor buys a security directly from the issuer