WHAT ARE BONDS?

What is a bond?

In simple terms, bonds are a form of debt. Just as you might take out a loan to buy a car or a house, bonds are a way for governments to borrow money to pay for infrastructure projects, the military and other services, or for corporations to fund their operations, make acquisitions, or pay for share buybacks.

Bond investors, also know as bondholders, are compensated for lending their money for a promise of the repayment of principal (initial investment amount) at a future date (maturity date) plus a periodic coupon or interest payments. Bond coupons are typically paid on a set schedule, such as twice a year, one reason why bonds are often referred to as “fixed income”.

How can you buy a bond?

Bonds have traditionally been purchased through a direct auction or via a broker, which can be challenging for individual investors. Exchange-traded funds (ETFs) make it easy to invest in a basket of bonds.

ETFs are a type of fund that often seek to track a benchmark like the S&P 500 or the Bloomberg Aggregate Bond Index. ETFs can make investing simpler, faster, and cheaper. ETFs can also help provide diversification compared to selecting a single stock or bond.

Bond ETFs are funds that invest in a basket of bonds. Picking individual bonds can be challenging, time-consuming, and expensive; bond ETFs allow you to buy a broad portfolio of bonds with the click of a button, for a known price and relatively low fee.

While past returns don’t guarantee future performance, bonds have historically played three important roles in portfolios, offering potential income, capital preservation, and diversification benefits.

Generate income

Investors can use bonds to generate income as most bonds seek to pay a coupon on a regular schedule. Bond investors typically receive payments, known as a coupon, on a regular schedule. Whether based on a fixed or floating interest rate, these payments can help generate income, which is the most direct way bonds can help you make money.

Preserve Capital

Bonds can be used to preserve the value of your investments and help provide more yield than idle cash. An investment in fixed income funds is not equivalent to and involves risks not associated with an investment in cash.

Diversification

Bonds can help diversify equity portfolios, potentially lowering the risk of all of your investments falling at the same time. Bonds have historically acted as a counterbalance to stocks. Going back to 1976, there have only been two years where bonds didn’t go up when stocks went down.¹

Are bonds a good investment?

Now that you better understand the role bonds play in a portfolio, you may then consider investments that can help you pursue your goals. Picking individual bonds can be challenging, time-consuming, and expensive. Bond ETFs allow you to buy a broad portfolio of bonds with the click of a button, for a known price and relatively low fee.

The role of fixed income in your portfolio

When managing a fixed income allocation within a portfolio, investors need to consider what role each holding plays in the overall asset mix. The BlackRock Bond Pyramid is designed to help investors visualize the significant role bonds have historically played in diversified, long-term portfolios.

What is a bond?

A bond is a loan made to a company or government in exchange for income. The income is typically paid out on a regular basis and is commonly referred to as a coupon payment.

The amount of money a bond issuer borrows is commonly referred to as the principal amount. The bond's maturity date is when the principal amount is scheduled to be repaid to investors. Ultra short-term bonds will mature between 0-6 months, short-term bonds will mature within 1-3 years, intermediate-term bonds will mature between 4-10 years and anything beyond is considered a long-term bond.

Another term you may have come across is yield, which is the annual expected return on a bond, expressed as a percentage rate. Yields move inversely with bond prices, which typically fall when interest rates rise.

What are the risks with bonds?

These are the main types of risks you should be aware of:

Interest rate risk

Interest rate risk is the risk of a bond’s price falling as interest rates rise. A bond’s price and its yield move in opposite directions. Duration, defined as the change in value of a bond for a 1% change in interest rates, is one indicator of how sensitive a bond’s price is to changes in interest rates. The longer the duration, the greater the change of a bond’s price may be in response to a change in interest rates. (Learn more about bond duration)

Credit risk

The risk of a default, meaning the company or government that issued a bond can’t (or won’t) pay investors back. Independent parties known as “ratings agencies” will assign letter ratings to individual bonds, which are designed to indicate the issuer’s relatively ability and willingness to repay its debts. Credit quality scores range from Aaa — judged to be of the highest quality — to C; bonds that aren’t paid in full or on time are rated “D” for default.²

Liquidity risk

The risk there isn’t anyone in the market willing to buy your bonds if you wish to sell and vice versa. The price may decline if you attempt to sell a bond prior to its maturity, the date at which a bond issuer promises to repay your original principal and (typically) makes a final interest payment.

Inflation risk

The risk that inflation could erode the value of the interest payments of your bonds. Longer-dated bonds, meaning bonds with a maturity date farther in the future, are typically considered to have more inflation risk. As a result, longer-dated bonds typically offer a higher yield to compensate investors for taking on said risk.

Volatility

As with stocks, bond prices can fluctuate daily or over longer periods of time. The volatility of a bond depends on a variety of factors but changes in interest rates are the most common driver of bond price volatility.³

Government bonds

Issued by governments to fund government spending or pay existing debt.  In the U.S. there are two main types of government bonds:

U.S. government bonds, aka "Treasuries"

Generally considered to be the safest investments, because they are backed by the full faith and credit of the U.S. government. In other words, the probability that you won't get paid back is generally viewed as very low.

Municipal or “muni” bonds

Issued by states, cities, counties or local government entities. Income from certain municipal bonds is exempt from federal taxes; some munis are also free from state and local taxes.

Corporate bonds

Issued by corporations to raise money for different purposes. Corporate bond yields tend to be higher than government bonds to compensate investors for the increased risk that companies won’t pay you back. There are two main types of corporate debt:

Investment grade

A bond issued by a company to raise money for various purposes and has been rated by an independent credit rating agency to be high quality (Baa/BBB or higher).

High yield

Bonds rated BB+ or lower, which have higher credit risk; investors are typically offered higher yields. These bonds are typically issued by smaller companies with riskier business models or by governments with a lower ability or willingness to repay investors.

Categories of sectors of bonds

Taxable vs. tax-exempt bonds

Most bonds are taxable, meaning the income that bonds produce is taxable. On the other hand, the income from tax-exempt bonds, like tax-exempt municipal bonds, may be exempt from Federal, state, and local taxes.

Emerging market (EM) bonds

Issued by government or corporations in developing countries. EM bonds tend to yield more than U.S. bonds with similar credit qualities to compensate investors for the additional risk.

Floating Rate Notes

A bond that has a variable coupon that periodically resets based on a short-term interest rate, such as the Secured Overnight Financing Rate (SOFR) or the yield on 3-month Treasury bills.

TIPs and Inflation Protected Bonds

Treasury Inflation-Protected Securities or TIPS, are issued by the U.S. Treasury Department and their value adjusts with inflation, helping you protect the bond’s value against inflation.

Mortgage-backed securities (MBS)

Securities formed by bundling home mortgages together. Mortgages issued by a bank are pooled together and sold to government sponsored-enterprises or to a securities firm to be used as collateral for the new mortgage-backed security. Most MBS are issued or guaranteed by government-sponsored entities, such as Ginnie Mae, Fannie Mae, or Freddie Mac.

Commercial mortgage-backed securities (CMBS)

CMBS are formed by bundling commercial property mortgages like office buildings, apartment buildings, and hotels. Some CMBS are guaranteed by government entities, while other CMBS bonds are not government guaranteed and rely on the cash flows from the underlying properties.

Asset-backed securities (ABS)

Pools of loans bundled together and sold to investors. The types of loans in ABS include mortgages, auto loans, home equity loans, student loans, and credit card receivables.