Bonds are often described as the most straightforward instrument in the stock market. You lend money to a company or a government and receive a predictable return in exchange. Here, we explain how bonds work, how investors make money from them, and how to choose the right securities.
What is a bond?
“A bond is a debt security”.
The entity that issues the bond is called the issuer. The issuer raises funds from investors and commits to repaying them by a specific date, while paying regular interest for the use of those funds. When you buy a bond, you are essentially lending money, and you know in advance exactly how much you will get back and when.
Each bond is defined by a set of parameters established by the issuer at the time of issuance:
Face value (or par value of a bond) — the principal amount of the debt per bond that will be repaid at maturity.
Coupon — the interest payment the holder receives at set intervals. The rate is expressed as an annual percentage of the face value and depends on the issuer’s creditworthiness, the bond’s term, and the current key interest rate.
Maturity date — the day the issuer repays the face value. After this date, the bond ceases to exist.
Let’s look at an example. A coffee shop chain plans to expand and issues three-year bonds. The face value is $1,000, and the coupon rate is 12% per annum, paid semi-annually—meaning $60 per bond. You buy ten bonds for $10,000. Every six months, you receive $600 in coupon income. After three years, the issuer repays the $10,000 face value, and you have earned $3,600 in interest during that time.
Bonds are traded on the stock exchange, so you do not have to wait until maturity; you can sell the bond at any time. You do not lose the interest accrued since the last coupon payment: the buyer compensates the seller for this amount during the transaction. This sum is known as accrued coupon income.
Investors entering the stock market for the first time often choose between bonds and stocks. The difference between them lies in the nature of the relationship with the issuer. A shareholder becomes a co-owner of the business and profits from the company’s appreciation and dividends, but also shares in its losses. A bondholder is a creditor: they receive a fixed income, and the issuer is obligated to repay the debt regardless of its financial results.
What kind of bonds are there?
Bonds are classified according to several criteria. The most important for an investor is the type of issuer, as this directly determines the security’s reliability and the size of the coupon payment:
Federal loan bonds. Obligations associated with these are backed by the federal budget, making them the most reliable securities on the market. The trade-off is a relatively modest yield.
Municipal bonds are issued by regions and municipalities. They carry slightly higher risk than federal loan bonds, and the coupon yield is generally higher as well—serving as compensation for that additional risk.
Corporate bonds are issued by companies. The range of yields here is the widest. Securities from large corporations with high credit ratings offer yields close to those of federal loan bonds. Bonds from lesser-known issuers may offer significantly higher coupons, but the probability of default is also higher.
In addition to the issuer type, bonds differ by maturity. Short-term bonds have a maturity of up to three years; medium-term bonds, three to seven years; and long-term bonds, seven years or more. There are also perpetual issues, where the issuer pays coupons indefinitely but is not obligated to repay the principal amount on a specific date.
Another criterion is the coupon type. It can be fixed—where the rate is set for the entire term of the bond—or floating, where the payment amount is pegged to a market indicator, such as the Central Bank’s key interest rate.
What makes up the income from bonds?
“There are three ways to make money on bonds: through coupon payments, the difference between the purchase price and the face value, and reselling the security on the exchange”.
Coupon income is the primary and most predictable source of earnings. The issuer pays the coupon regularly, regardless of fluctuations in the bond’s market price. If you purchase a bond with an 11% annual coupon and a face value of $1,000, you will receive $110 per year in installments, depending on the payment schedule. Coupon payments are credited to your brokerage account automatically; no further action is required on your part.
Income from redemption arises when you purchase a bond for less than its face value. Market prices fluctuate daily based on supply, demand, and the key interest rate. If a bond with a face value of $1,000 trades at $940 and you hold it until maturity, the issuer will repay the full face value. The $60 difference represents additional income on top of the coupon payments. The reverse can also occur: if a bond is purchased above face value, that price difference effectively “eats into” a portion of the coupon income upon redemption.
Income from resale works simply: buy low, sell high. Suppose the key interest rate drops, making high-coupon bonds more attractive and driving up their market price. By selling the bond at that point, you lock in a profit without waiting for maturity.
To assess the total return on an investment, investors look at the yield to maturity (YTM). This metric accounts for coupon payments, the difference between the current price and the face value, and the time remaining until maturity. It is the most convenient figure to use when comparing different bond issues.
Pros and cons of bonds
Bonds offer several notable advantages over other securities:
Predictable income. The coupon amount, payment frequency, and maturity date are known in advance. You can calculate the expected return before purchasing and know exactly when you will receive payments.
Low entry barrier. You do not need significant capital to get started, and you can build a diversified portfolio of securities from multiple issuers even with a small amount of money.
Flexibility. Bonds can be sold on any trading day without waiting for maturity. You do not lose the accrued interest in the process.
Tax benefits. These apply if you purchase the securities through an Individual Investment Account (IIA).
There are also risks that are important to consider:
Credit risk. Bonds are not government-insured. If the issuer lacks the funds to make payments, they may fail to redeem the securities—a situation known as default. Choosing securities with a high credit rating helps mitigate this risk.
Interest rate risk. When the key interest rate rises, the value of fixed-coupon bonds falls. If you hold the security until maturity, this is not a problem, as the issuer will repay the full face value. However, selling early could result in receiving less than your initial investment.
Inflation risk. If inflation exceeds the coupon rate, the real return decreases. Bonds with floating coupons linked to the key interest rate offer partial protection against this.
Overall, bonds are one of the most balanced instruments for those seeking regular income and control over risk levels. The key is to carefully select the issuer and the term, rather than simply chasing the highest coupon rate.
How to choose bonds?
When selecting bonds, consider several criteria.
Maturity. Determine how long you are willing to invest your funds. Short-term issues (up to three years) are less sensitive to key interest rate fluctuations, and your capital is returned relatively quickly. Long-term securities allow you to lock in a high yield for years to come, though their market price tends to fluctuate more significantly over their lifespan.
Issuer credit rating. This indicates the likelihood that the issuer will meet its obligations. Ratings are assigned by accredited agencies using a scale ranging from AAA (maximum reliability) to CCC (high risk of default). If you are just starting out as an investor, it is wise to choose securities with a rating of A or higher. These typically include federal government bonds, as well as bonds issued by regions and major corporations.
Coupon type. Coupons can be either fixed or floating. A fixed coupon is preferable when market rates are high and you want to lock in an attractive rate. A floating coupon is a better choice when the key interest rate is expected to rise and you want to avoid being stuck with a coupon rate that falls below market levels.
Liquidity. Before buying, check how actively the security is traded on the exchange. If trading volume is low, it will be difficult to sell the bond quickly at a fair price. You can always check trading volumes on the exchange’s website or via your broker’s app.
Bonds are one of the most accessible ways to start investing. You do not need substantial capital or deep knowledge of the stock market to build your first portfolio.
