Bonds and Treasuries Explained: How Lending Money Can Earn Interest

Bonds are often called fixed-income investments because they typically pay regular, predictable interest. They play an important role in many portfolios, providing income, stability and diversification alongside stocks. Here’s how bonds work and the main types everyday investors use.

How bonds work

When you buy a bond, you’re essentially lending money to the issuer, which could be a government, government agency or company. In return, the issuer generally agrees to pay you interest, called the coupon, at regular intervals, often every six months, and to return your original investment, called the principal or face value, on a set date, known as the maturity date.

For example, if you buy a $1,000 bond with a 4% coupon and a 10-year maturity, you would typically receive $40 in interest each year, often paid as $20 every six months, and receive your $1,000 back at the end of 10 years, assuming the issuer doesn’t default.

Bonds come with different maturities, from short-term bonds that mature within a few years to long-term bonds that may mature in 20 or 30 years. Longer-term bonds often pay higher interest rates to compensate investors for tying up their money longer and for greater sensitivity to interest rate changes.

Types of bonds

U.S. Treasury securities are issued by the federal government and backed by its full faith and credit, making them among the safest investments in the world. Treasury bills mature in a year or less and are sold at a discount to their face value. Treasury notes mature in two to 10 years and pay interest every six months. Treasury bonds mature in 20 or 30 years and also pay interest every six months. Treasury Inflation-Protected Securities, or TIPS, adjust their principal based on inflation, helping protect purchasing power.

Savings bonds are sold by the Treasury to individuals. Series I bonds earn interest based on a combination of a fixed rate and an inflation rate, helping protect against inflation. Series EE bonds earn a fixed rate and are guaranteed to double in value if held for 20 years. Savings bonds can’t be traded and have purchase limits and holding requirements.

Municipal bonds are issued by state and local governments to fund projects like schools, roads and hospitals. Interest is often exempt from federal income tax and sometimes from state and local taxes for residents of the issuing state, which can make them attractive to investors in higher tax brackets.

Corporate bonds are issued by companies to raise money. They generally pay more interest than government bonds, but they carry more risk, since companies can face financial difficulties. Investment-grade corporate bonds are issued by financially strong companies, while high-yield bonds, sometimes called junk bonds, are issued by companies with weaker credit and pay higher interest to compensate for greater default risk.

Buying Treasuries

You can buy Treasury securities and savings bonds directly from the U.S. government at TreasuryDirect.gov, without paying commissions. Treasury securities can also be bought through a brokerage account, either when they’re first issued or on the secondary market. Savings bonds are generally available only through TreasuryDirect.

Interest on Treasury securities is generally exempt from state and local income taxes but is subject to federal income tax, which can be an advantage for investors in high-tax states.

Interest rates and bond prices

Bond prices generally move in the opposite direction of interest rates. When interest rates rise, newly issued bonds pay higher interest, making existing bonds with lower rates less attractive. As a result, the prices of existing bonds fall. When interest rates fall, existing bonds with higher rates become more valuable, and their prices rise.

Longer-term bonds are generally more sensitive to interest rate changes than shorter-term bonds. A measure called duration helps estimate how much a bond’s price may change when rates change.

If you hold a high-quality bond to maturity, you generally get your principal back regardless of price swings along the way, assuming the issuer doesn’t default. Price changes matter mainly if you need to sell before maturity.

Bond funds

Bond mutual funds and ETFs hold many different bonds, offering diversification across issuers, maturities and sometimes types of bonds. They make it easy to invest in bonds with small amounts of money and provide professional management.

Unlike individual bonds, most bond funds don’t have a maturity date. The fund continuously buys and sells bonds, so its value can rise and fall with interest rates over time, and you’re not guaranteed to get your original investment back at a specific date. However, as rates rise, bond funds reinvest in higher-yielding bonds, which can increase their income over time.

The role of bonds in a portfolio

Bonds can provide steady income, reduce overall portfolio volatility and help cushion stock market declines. Many investors gradually increase their bond holdings as they approach retirement to reduce risk. The right amount depends on your goals, timeline and comfort with risk.

This article is for education only and isn’t investment advice.