Understanding Types of Bonds: What They Are and How They Work
Bonds are financial tools used by governments, corporations, and municipalities to raise capital. There are different types of bonds that serve different purposes. We can help guide you through how bonds work, so you can make smart choices about using bonds in your investments.
What is a bond?
A bond is a type of loan that companies or governments use to raise money. When you invest in a bond issued by a company, for example, you’re lending money to that company for a certain amount of time in exchange for a return on your investment.
How do bonds work?
Here is an example of how bonds work:
A city needs to build a new bridge that costs $1 million. The city issues 1,000 bonds, at $1,000 each and a 5% annual interest rate.
Investors buy the bonds, providing the city with the $1 million needed for the project. In return, the city pays each investor, also called a bondholder, $50 per year (5% of $1,000) as interest.
After a period determined at the time of the bond purchase, say 10 years, the city repays the $1,000 to each bondholder, completing the loan agreement.
Types of bonds
There are several types of bonds available that offer distinct features, risk profiles, investment objectives and risk tolerances.
This bond is issued by the U.S. government to raise funds for public projects or to manage debt. It's generally considered safe because governments can tax citizens to repay bondholders.
This type of bond is issued by corporations to raise capital for purposes such as expansion, acquisitions or day-to-day operations. Corporate bonds typically offer higher interest rates than government bonds but also carry higher risks of default. This higher risk is because if something happens to the corporation, like a bankruptcy, they aren’t able to pay back the money you lent.
Municipal bonds are issued by local governments, municipalities or agencies to finance public projects such as schools, roads or utilities. These differ from U.S. Treasury bonds in that you are investing in a smaller, more localized area. Municipal bonds often offer tax advantages and are generally considered relatively safe investments.
These bonds are issued by government-sponsored enterprises (GSEs), such as Fannie Mae, Freddie Mac and the Federal Home Loan Bank, to fund specific public initiatives, such as housing or infrastructure projects. These bonds are considered to have slightly higher risk than U.S. Treasury bonds but typically offer higher yields.
These are a type of government bond issued by the U.S. Department of the Treasury as a means of borrowing money from individual investors. They’re often used by investors for educational expenses, retirement savings or as gifts to family members. They are considered low-risk investments and typically have fixed interest rates, meaning the interest rate remains constant throughout the bond's term.
Certificates of deposit are offered by banks, including KeyBank, which pay a fixed interest rate over a specified term. While not technically bonds, CDs are low-risk, interest-bearing investments that can be an alternative to traditional bonds for conservative investors.
Understanding bonds as investments
Bonds offer can offer several benefits that can make them good investments for various situations and goals:
- Provide regular income
Bonds earn interest payments, which can be attractive for income-seeking or conservative investors. - Considered safer investments
Compared to stocks, bonds have lower volatility and more predictable cash flows. - Can reduce risk
Because bonds can help diversify an investment portfolio, they reduce overall investment risk.
How to buy bonds
Since they aren’t publicly traded like stocks, you must buy most bonds through a broker. Government bonds can be purchased directly through government-sponsored websites.
How to buy bonds with Key Investment Services:
- Open a brokerage account
Open a Key Investment Services brokerage account online, at a local branch, or by calling 1-800-KEY2YOU (1-800-539-2968). - Choose your bonds
Our financial professionals can review your investment goals and risk tolerance, and provide guidance on the types of bonds that might be suitable for your portfolio. - Place an order
Place an order through your Key Investment Services brokerage account online, or by contacting your financial professional or the Key Investment Services team. - Monitor your investment
Track your bond performance and any changes in interest rates or credit ratings, easily and securely online or with the help of your financial professional.