Bonds are among a number of investments known as fixed-income securities. They are debt obligations, meaning that the investor loans a sum of money (the principal) to a company or a government for a set period of time, and in return receives a series of interest payments (the yield). When the bond reaches its maturity, the principal is returned to the investor.
Key Takeaways
- A coupon-paying bond pays a pre-determined amount of interest, usually twice a year until the date the bond matures.
- A zero-coupon bond is bought at a discount from its face value, and the investor receives the full face value when it matures.
- The interest paid on a bond may be pre-set or may be based on prevailing interest rates at the time it matures.
Making Money From a Coupon-Paying Bond
There are two ways that investors make money from bonds.
- The individual investor buys bonds directly, with the aim of holding them until they mature in order to profit from the interest they earn. They may also buy into a bond mutual fund or a bond exchange-traded fund (ETF).
- Professional bond traders dominate a secondary market for bonds, where existing issues are bought and sold at a discount to their face value. The amount of the discount depends partially on how many payments are still due before the bond reaches maturity. But its price also is a bet on the direction of interest rates. If a trader thinks interest rates on new bond issues will be lower, the existing bonds may be worth a little more.
In either case, the owner of the bond receives interest payments,known as the coupon, throughout the life of a bond, at the interest rate that was determined when it was issued.
For instance, if you invested $1,000 in a 10-year bond with a coupon rate of 4%, the issuer would send you a coupon (interest) payment of $40 every year. Most bonds pay twice a year, so you would receive two checks for $20 each.
Making Money From a Zero-Coupon Bond
Investors in zero-coupon bonds receive no payments for their money until the bond matures. They buy the bond for an amount that is less than its face value. When it reaches its maturity, they are paid the full face value of the bond.
The zero-coupon bond also is known as a discount bond. U.S. Treasury bills (T-bills) and U.S. savings bonds are two examples.
In the secondary bond market, bondsmay bebought and sold at a discountor premiumto their face value based on the number of payments outstanding, plus the trader's bet on the direction of interest rates
Most zero-coupon bonds have a pre-set face value and therefore pay a pre-set amount of moneyat maturity. Some bonds are inflation-indexed, meaning the face value is determined at maturity. The amount paid will be based on a standard measure such as the consumer price index plus a premium.
Types of Zero-Coupon Bonds
Bonds are issued with maturity dates that vary in their length of time.
Zero-coupon bonds that are considered short-term investments typically have a maturity of no more than one year. These short-term bonds are usually called bills.
A zero-coupon bond that is a long-term investment may have a maturity date of 10 to 15 years or more.
Coupon-Paying Bond Vs. Zero-Coupon Bond
Coupon-paying bonds are a frequent choice of older investors and retirees who value the steady income that the payments provide and the relative safety of bonds as an investment.
Those short-term Treasury bills have the same benefits as reliable income supplements and safe investments.
The long-term zero-coupon bond holds little attraction for most older investors and retirees, who are unlikely to want to tie up their money for decades.
Such a long-term bond might, however, be useful as part of a young family's savings plan. It also can be used by wealthy investors as a vehicle for passing on an inheritance.
Tax Benefits of Zero-Coupon Bonds
Zero-coupon bonds issued in the U.S. retain an original issue discount (OID)for tax reasons.
Zero-coupon bonds often input receipt of interest payment, or phantom income, despite the fact the bonds do not pay periodic interest.For this reason, zero-coupon bonds subject to taxation in the U.S. can be held in a tax-deferred retirement account, allowing their investors to avoid tax on future income.
If a zero-coupon bond is issued by a U.S. local or state government entity, interest is free from federal tax and generally exempt from state and local tax as well.
FAQs
A bond is simply a loan taken out by a company. Instead of going to a bank, the company gets the money from investors who buy its bonds. In exchange for the capital, the company pays an interest coupon, which is the annual interest rate paid on a bond expressed as a percentage of the face value.
How do bonds generate income from investors? ›
In return for buying the bonds, the investor – or bondholder – receives periodic interest payments known as coupons. The coupon payments, which may be made quarterly, twice yearly or annually, are expected to provide regular, predictable income to the investor.
What two ways can an investor make money on bonds? ›
By making your initial investment and letting time do its thing, you can regularly collect interest payments until your bond matures. 2. Earning capital gains: Many bonds are not held until maturity, as an investor you may choose to sell your bond before it reaches its maturity date.
How do investors benefit from owning bonds? ›
Bonds tend to be less volatile and less risky than stocks, and when held to maturity can offer more stable and consistent returns. Interest rates on bonds often tend to be higher than savings rates at banks, on CDs, or in money market accounts.
Can you lose money on bonds if held to maturity? ›
TAKEAWAYS: Not losing money by holding a bond until maturity is an illusion. The economic impact of market rate changes still impacts investors holding bonds until maturity. A bond index fund provides an investor with greater diversification and less risk.
How do investors get paid when they own bonds? ›
By buying a bond, you're giving the issuer a loan, and they agree to pay you back the face value of the loan on a specific date, and to pay you periodic interest payments along the way, usually twice a year.
How do investors earn a return on bonds? ›
There are two ways that investors make money from bonds. The individual investor buys bonds directly, with the aim of holding them until they mature in order to profit from the interest they earn. They may also buy into a bond mutual fund or a bond exchange-traded fund (ETF).
What are cons of bonds? ›
Cons
- Historically, bonds have provided lower long-term returns than stocks.
- Bond prices fall when interest rates go up. Long-term bonds, especially, suffer from price fluctuations as interest rates rise and fall.
But generally, cash and government bonds—particularly U.S. Treasury securities—are often considered among the safest investment options available. This is because there is minimal risk of loss. That said, it's important to note that no investment is entirely risk-free.
Do bonds pay interest monthly? ›
Both bonds and notes pay interest every six months. The interest rate for a particular security is set at the auction. The price for a bond or a note may be the face value (also called par value) or may be more or less than the face value. The price depends on the yield to maturity and the interest rate.
Similar to callable bonds, the rationale behind putable bonds is related to the inverse relationship between interest rates and the price of bonds. Since the value of the bonds declines as interest rates rise, they provide investors with protection from potential interest rate increases.
How do bonds work for dummies? ›
A bond is simply a loan taken out by a company. Instead of going to a bank, the company gets the money from investors who buy its bonds. In exchange for the capital, the company pays an interest coupon, which is the annual interest rate paid on a bond expressed as a percentage of the face value.
Are bonds riskier than stocks? ›
Given the numerous reasons a company's business can decline, stocks are typically riskier than bonds. However, with that higher risk can come higher returns. The market's average annual return is about 10%, not accounting for inflation.
Are bonds safe if the market crashes? ›
Bonds usually go up in value when the stock market crashes, but not all the time. The bonds that do best in a market crash are government bonds such as U.S. Treasuries. Riskier bonds like junk bonds and high-yield credit do not fare as well.
What happens to bonds during a recession? ›
In every recession since 1950, bonds have delivered higher returns than stocks and cash. That's partly because the Federal Reserve and other central banks have often cut interest rates in hopes of stimulating economic activity during a recession. Rate cuts typically cause bond yields to fall and bond prices to rise.
How do you make money from a bond? ›
There are two ways to make money on bonds: through interest payments and selling a bond for more than you paid. With most bonds, you'll get regular interest payments while you hold the bond. Most bonds have a fixed interest rate. Or, a fee you get to lend it.…
How does buying bonds create money? ›
The Fed increases the money supply in the economy by swapping out bonds in exchange for cash to the general public when it buys bonds in the open market. It decreases the money supply by removing cash from the economy in exchange for bonds when it sells bonds.
How do bond funds pay income? ›
Unlike individual bonds, which usually make semiannual interest payments, bond funds usually make monthly distributions that can be paid directly to the investor or reinvested into the fund to compound returns.
How does a bond dealer generate profits? ›
Bond Market Considerations
A markup is when a broker buys a bond at a low price, then shortly thereafter resells it to an unaware customer at a higher price. The broker makes their money from the spread of the buy and sell transaction.
Do bonds generate interest income? ›
Bond yield is the return an investor will realize on a bond and can be calculated by dividing a bond's face value by the amount of interest it pays. A bond ladder is a portfolio of fixed-income securities with different maturity dates. Read how to use bond ladders to create steady cash flow.
