Most of us understand how stocks work and where to buy them. However, many investors consider bonds a bit of a mystery. Below, we take a look at what bonds are, how they work and how to buy bonds.

What is a bond?

Stocks represent ownership in a company. If you own shares of Apple, for example, you are an owner of the company and you participate in the ups or downs of the stock.

Bonds, however, represent a loan from the buyer to the issuer. Corporations, the United States Treasury, various federal governmental agencies, state and municipal governments issue bonds. Foreign governments and corporations can also issue bonds. Bonds are considered to be debt obligations on the issuer that will be paid back to the investor when the bond matures.

A typical corporate bond has a par value — face value — of $1,000 per bond. If you purchase a bond for that amount, the money is loaned to the corporation or agency that issued it. In return, you earn a specified rate of interest at regular intervals, usually every six months. For example, if the bond pays a 4% annual interest rate — or coupon rate — you would receive an interest payment of $20 every six months.

If the bond is held until maturity, the bond is redeemed by the issuer and the bondholder receives the face value of the bond. Holding a bond until it matures will result in a certain return. However, if you sell the bond before it matures, it could be worth more or less than what you paid for it, or less than the face value of the bond.

What types of bonds are there?

As mentioned above, there are many types of bonds and bond issuers. Some examples include:

• Treasury notes, bills and bonds. These are issued by the U.S. government and are secured by the full faith and credit of the U.S. government. They are considered the least risky of all bonds and debt securities. Interest paid on all Treasury securities are exempt from state and local taxes but are subject to federal taxes.
• Corporate bonds. These are issued by private corporations. Corporate bonds are backed by the financial ability of the issuing corporation to make periodic interest payments. They are riskier than Treasuries in general, and within the universe of corporate bonds, the risks will vary widely.

  Corporations in solid financial shape should have no trouble making interest payments and repaying the bondholders when the bonds mature. But for corporations with financial issues, that may not be the case. In extreme cases, corporations have defaulted on their bonds. This is a very serious situation that can have dire consequences for the company and its shareholders, not to mention the holders of their bonds.

• Municipal bonds. These bonds are issued by state and local governments, including counties and other governmental entities. Interest on municipal bonds are often exempt from federal taxes and may be exempt from state income taxes for residents of the state where the issuer is located.

  Municipal bonds are not considered as safe as those issued by the U.S. Treasury. These bonds are only as secure as the governmental entity backing them. When Detroit filed for bankruptcy in 2013, for instance, bondholders received back only a portion of their money.

• Foreign bonds. Foreign bonds are issued by non-U.S. corporations or governments. There are many types of bonds issued by entities located outside of the United States, and these bonds can face political risk associated with the country in question.

  For U.S. investors, there is also currency risk that’s associated with most types of investments in foreign securities. For example, a strong U.S. dollar will reduce returns for U.S. investors, all else being equal.

Factors influencing bond price and yield

The value of a bond moves inversely with the direction of interest rates. For example, a bond that pays 4% interest will increase in value if interest rates decline and it will be worth less if interest rates move up in value.

Let’s return to our example of a $1,000 bond with a 4% interest rate. If interest rates on similar bonds decline to 3%, then the value of your 4% bond could increase. Because similar bonds offer a lower interest rate, you can sell your higher-interest bond for more money. You might sell your bond for $1,333 on the secondary market, which gives the buyer a yield of 3% based on the $40 annual interest payment.

Note these calculations are just approximations as other factors play into the price of a bond on the secondary market. The price of bonds may fluctuate on the secondary market, but bonds held to maturity will still be paid out at their original face value.

Bond ratings

The three major ratings agencies — Moody’s, Standard and Poor’s, and Fitch — rate corporate and municipal bonds. Each agency uses slightly different ratings, but all three are similar. Below is an example of Standard and Poor’s rating system.

Standard and Poor’s Ratings

• AAA is the highest and denotes the highest level of creditworthiness.
• AA bonds indicate very strong creditworthiness.
• A bonds indicate strong creditworthiness.
• BBB bonds are considered to have adequate creditworthiness. This ranking is the lowest rating that is still considered investment-grade.

The next set of ratings are considered below investment-grade — or “junk” — and carry a high amount of risk:

• BB
• B
• CCC
• CC
• C

Bond ratings help determine the interest rate the issuer will pay on their bonds in order to entice bond buyers to invest in them. Issuers with top ratings can pay less than those whose bonds are rated less than investment-grade.

How to buy bonds

Treasury bonds, bills and other securities can be purchased directly from the U.S. Treasury via Treasury Direct.

You will need to open an account on the site and agree to accept the yield determined at the most recent auction. Treasury securities are sold to smaller investors via periodic auctions. Larger investors and institutions can make what are called “competitive bids” for large blocks of these newly issued securities.

Treasury securities can also be purchased via banks, brokers and Treasury securities dealers. You can enter a competitive bid specifying the yield you will accept; depending on what the final yield is based on the auction, you may or may not receive the securities you are bidding on. With a non-competitive bid, you agree to accept the average yield from the auction and will receive securities in the amount you bid.

You can generally purchase non-Treasury bonds via full-service or discount brokerage firms. The price you pay for the same bond may vary from broker to broker based on spread, defined as the difference between what the broker pays for the bond and what you pay the broker. There may also be commissions or transaction fees.

The secondary market for bonds that are being bought and sold is much less transparent than most stock markets. Sometimes this can lead to less liquidity for those who are looking to buy or sell bonds, resulting in a larger spread.

Bond funds and ETFs

For smaller investors, it may be more efficient to invest in bonds via bond mutual funds and exchange-traded funds (ETFs). These funds pool investors’ money and purchase a wide range of bonds.

Just as with stock funds and ETFs, there are bond funds across the spectrum of bonds. There are bond funds that own corporate bonds, Treasury securities and municipal bond funds. Additionally, there are bond funds that own bonds with longer terms to maturity, bonds with an intermediate term to maturity and bonds with a short-term maturity.

Final thoughts

Bonds can represent a part of a diversified portfolio for many investors. Bonds react differently to market and economic factors than stocks, and can serve to reduce the overall risk in an investment portfolio.

Understanding how to buy bonds and the right type of bond for your financial situation can help you build a stronger investment portfolio.