How Bonds Work

When you buy a stock, you become a part-owner of a company. When you buy a bond, you're doing something completely different: you're lending money to whoever issued it, and they're promising to pay you back with interest.

Bonds are issued by governments (US Treasury bonds are the most common example), state and local governments (municipal bonds), and corporations. When the US government runs a deficit and needs to borrow money, it issues Treasury bonds. Investors buy them, the government gets cash, and it pays interest over the life of the bond — then returns the original amount at the end.

Here's something that confuses a lot of people at first: when interest rates rise, bond prices fall. When interest rates fall, bond prices rise. They move in opposite directions.

The reason is straightforward once you think it through. Say you own a bond paying 3% interest. Then rates rise and new bonds now pay 4%. Your 3% bond is suddenly less attractive — nobody would pay full price for it when they could get better terms elsewhere. So its price drops until the effective yield is competitive.

The longer a bond's maturity (the time until it pays back the original amount), the more sensitive its price is to interest rate changes. A 30-year bond moves much more than a 1-year bond when rates shift.

The two main types work the same way mechanically but carry different risk levels.

US Treasury bonds are backed by the US government and are considered essentially risk-free in terms of default (the government can always print dollars to repay). Because the risk is low, the interest rate is also lower.

Corporate bonds are issued by companies. A bond from Apple or Microsoft is very unlikely to default — but a bond from a struggling retailer carries real risk. Higher risk means higher interest rates to attract buyers. Bonds from financially weak companies are sometimes called high-yield bonds, or less charitably, junk bonds.

• Treasury bonds — issued by the US government, lowest risk, lowest return
• Municipal bonds — issued by states/cities, often tax-advantaged for investors
• Investment-grade corporate bonds — issued by financially stable companies
• High-yield bonds — issued by riskier companies, higher interest, higher chance of default

Bonds and stocks tend to move differently from each other — not perfectly opposite, but often enough that holding both smooths out the overall portfolio. When stocks crash, bonds sometimes hold their value or even gain. When stocks are surging, bonds lag behind.

Retirement portfolios typically shift toward more bonds as retirement approaches, because the priority changes. When you're 30, a 40% market drop is painful but recoverable — you have decades for the portfolio to come back. At 65, that same drop could permanently affect how much you can spend.