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Investing

What Are Bonds?

Bonds are a way for investors to loan money to governments, corporations, and other types of institutions. In exchange for borrowing money, the issuer of the bond agrees to pay the bond holder interest at a specified rate and repay the debt at a designated date in the future.

Eli Broverman

By Eli Broverman
President and Co-Founder, Betterment  |  Published: June 29, 2010

Bonds are typically lower risk than stocks because their interest rate establishes ahead of time what the investment is expected to return.  Because bonds carry less risk their returns tend to be lower than average returns for stocks. However, investors must factor in the possibility that the borrowed money won’t be repaid, and the risks and returns of bonds will certainly vary depending on the likelihood of default.

High Risk Bonds

For instance Treasuries, which are bonds issued by the U.S. Government, are particularly safe because it’s hard to imagine the U.S. Government won’t make due on its obligation (Treasuries are the type of bonds Betterment accounts are invested in). Due to the high certainty of repayment, returns for Treasuries are moderate .

On the other hand, if a company with a weak financial position issues a bond there will be serious questions about repayment and as a result the company will offer a high interest rate to entice lenders.  Especially risky and high yielding bonds are often called junk bonds.

The risks and returns of a bond depend not just on the credit worthiness of the issuer but also on the duration; bonds that have a long duration until repayment are higher risk and higher reward.

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