An Introduction to Bonds

A bond is a loan made by an investor to a borrower. They are often referred to as fixed income securities because they typically make scheduled interest payments and/or return a defined amount at maturity. 

Stocks and bonds are fundamentally different but play equally important roles in an investment portfolio. Stocks represent part ownership in a company, and bonds represent a liability. Incorporating bonds into an investment portfolio may help achieve a more predictable total return and lower volatility, while offering scheduled coupon payments, a known maturity date, and return of principal. 

Corporations issue far more individual bonds than governments, but government-related debt still accounts for roughly two-thirds of the global bond market value. Some of the most prevalent categories of bonds include government bonds, municipal bonds, agency bonds, and corporate bonds.

US Government Bonds 

Treasury bills (under 1-year maturity)*—Issued by the US government with a zero-coupon structure. These are sold at a discount to face value and do not provide periodic payments (coupons). Your return is the difference between what you paid and the face value at maturity. The minimum investment for a Treasury bill is $100, and purchases are made in $100 increments. Treasury bills are backed by the full faith and credit of the US government and therefore considered free of default risk.

Treasury notes (2–10-year maturity)* and Treasury bonds (20- & 30-year maturity)*—Both are issued by the US government at a fixed rate; these pay a set coupon every six months and lenders get their principal returned at maturity. Like Treasury bills, Treasury notes and bonds are also backed by the US government.

*Treasury bills, notes, and bonds all represent different points along the US Treasury yield curve. Yields along this curve are considered “risk-free.” 

TIPS—US government bonds that protect your purchasing power from inflation. Unlike normal Treasuries that pay a fixed dollar amount, a TIPS bond’s principal automatically adjusts with CPI (Consumer Price Index) inflation. Actual dollar payments rise with inflation over time, and at maturity you receive the greater of the inflation-adjusted principal or the original face value. This means your principal is never reduced by deflation, even as it stays fully protected against inflation.

Floating Rate Notes (FRNs)—The US government’s only floating-rate product, currently issued with a 2-year maturity. The coupon resets weekly based on the most recent 13-week Treasury bill discount rate, plus a fixed spread determined at auction. Wide spreads signify weaker demand while narrow spreads signify the opposite.

Other Government Bonds (Sovereign Bonds)

Conventional sovereign bonds—Issued by non-US governments. They follow the same basic fixed-coupon, semi-annual or annual pay structure as US Treasuries. Sovereign bond credit quality varies by issuer. Currency risk arises whenever the bond differs from the buyer’s currency, since returns will rise or fall with the exchange rate between the two.

Sovereign inflation-linked bonds—These apply the same principal-adjustment mechanic as US TIPS, adapted to each country’s own inflation index. Like conventional sovereign bonds, these carry credit and currency risks. 

Municipal bonds (US)*

General obligation (GO) bonds—These are issued by states, local governments, and sometimes school districts. They are backed by the issuer’s full taxing power, as they can raise property, income, and sales tax to whatever level necessary to service debt. GO bonds typically pay interest on a semi-annual basis.

Revenue bond—Backed by one specific income stream generated from specialized public entities and/or authorities like transit agencies, airport authorities, utilities providers (water, power, sewer) and sometimes school districts. These public entities and/or authorities protect bondholders using strict structural mechanisms including rate covenants (raising user fees, utility rates, toll prices, etc.), debt service reserve funds (dedicated cash reserve with a full year’s worth of principal and cash payments), and intercept programs (governments will “intercept” the amount of state aid required to make bondholders whole). Like GO bonds, these pay interest semiannually.

*Municipal bond interest is exempt from federal tax and often from state and local tax if you buy bonds issued in your own state. Because of this, a municipality’s after-tax yield can end up exceeding that of a comparable taxable bond, especially if you’re in a higher tax bracket.

Agency / Government-Sponsored Enterprise (GSE)

Agency bonds—Issued by government-sponsored enterprises of federal agencies which serve specific public policy goals like expanding mortgage credit, agricultural lending, or student loans. Fannie Mae and Freddie Mac are both GSEs that carry strong implicit government support without being directly backed by the full faith and credit of the US government (but there is implicit guarantee), and trade at a modest yield premium over Treasuries to compensate for that distinction. Banks sell loans to Fannie Mae and Freddie Mac to free up capital for new lending. They’re then pooled into mortgage-backed securities. Ginnie Mae securities are a notable exception, backed by an explicit full-faith-and-credit government guarantee. The agency does not take on mortgage credit risk. Instead, it guarantees payment while federal government insurance agencies guarantee return of principal on the loans and absorb all credit risk.

Corporate Bonds

Investment-grade bonds—Issued by financially healthy companies, rated BBB-/Baa3 or higher, where default is possible but statistically unlikely. They trade at a higher spread over Treasuries that widens or narrows depending on credit market sentiment.

High-yield (“junk”) bonds—These carry lower credit ratings than investment-grade bonds but offer meaningfully higher spreads as compensation. During market stress, high-yield bonds may fall alongside stocks, rather than preserving value the way investment grade bonds and government debt often do.

Bonds aren't a uniform asset class doing one job. A Treasury allocation and a high-yield allocation serve completely different purposes: capital preservation and predictable income on one end, enhanced yield with real credit risk on the other. When building a fixed income allocation, it is important to look past yield and understand the ways in which different bonds ensure repayment. Now that the groundwork has been laid, coming articles will dive deeper into the nuances and mechanisms of different types of bonds. In the meantime, please reach out to one of our wealth managers for more information on bonds. 

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