How Bonds Generate Income for Investors

Banks charge and collect interest payments when making a loan.

Similarly, investors typically can collect interest payments when they “lend” their money by buying bonds.

Let’s dive into the world of bonds and explore how they might work for you as a source of income.

Bonds Are Called Fixed Income for a Reason

A government, company or other institution issues bonds when it wants to borrow money for a project or expense. In most cases, the issuer/borrower agrees to pay investors interest on a regular basis for a set period. The issuer repays the face value of the bond when the security matures at the end of the stated time frame.

The interest payments are also known as coupon payments. This income is typically the primary component of a bond’s return, with changes in the bond’s price also contributing. Bond issuers set the coupon rate as a percentage of the bond’s face value, and it’s typically paid every six months.

For example, if you buy a $1,000 bond with a 4% coupon rate, you’ll receive $40 annually or $20 every six months.

You can also make money if you sell your bond before it matures for a higher price than you paid for it. For example, if you buy a bond with a $1,000 face value for $950 and it matures or you sell it for $1,000, you earn a $50 profit.

But you could also experience a loss. Bond prices fluctuate based on market conditions, interest rates and the issuer’s creditworthiness and thus are less predictable than coupon payments.

The Difference Between Coupon Rate and Yield

Understanding the difference between a bond’s coupon and its yield is important.

• A coupon rate is the fixed rate of interest a bond pays annually.

• A bond’s yield can change throughout the life of the security. Investors calculate yield in different ways, but the most common method is to divide the annual coupon payment by the bond’s current market price. This gives you the current yield, which reflects the bond’s income potential based on its current price.

• Yield to maturity is also a common calculation for fixed-income securities. It considers total annual interest payments, the purchase price, the redemption value and the amount of time remaining until maturity.

Total return is another important aspect to understand about fixed-income securities. It’s regarded as a more complete measurement of performance than yield alone. Total return incorporates both income (primarily from interest payments) and changes in the prices of the securities.

Types of Bonds and Their Income Potential

Different types of bonds come with varying income, risk and return profiles:

• U.S. Treasury bonds: Generally considered among the highest-quality and most liquid securities in the world, these bonds are issued by the U.S. Treasury Department. They are backed by the U.S. government's full faith and credit pledge. Treasury securities include bills (maturing in one year or less), notes (maturing in two to 10 years) and bonds (maturing in more than 10 years).

• Government agency bonds: U.S. government agencies created by Congress to fulfill specific needs, such as providing credit to homebuyers or farmers (Federal Home Loan Banks and Federal Farm Credit Banks), may issue bonds. Some agency bonds are backed by the full faith and credit of the U.S. government, while others are guaranteed only by the issuing agency.
  
  Agency securities typically offer slightly higher yields than U.S. Treasury securities with similar maturities. That's because these securities may involve a greater risk of default—when an issuer stops making its promised payments—than securities backed by the U.S. Treasury. There is no assurance that the U.S. government will provide financial support to a government agency when it is not obligated by law to do so.

• Municipal bonds: Issued by state and local governments and other public entities, these bonds usually provide tax-free interest income.^* Municipal bonds can be general obligation bonds, backed by the issuer’s taxing power, or revenue bonds, backed by specific revenue sources, such as tolls or utility payments.

Learn about our active approach to managing municipal bond portfolios.

• Corporate bonds: Issued by companies, these bonds typically offer higher yields than government debt but come with higher risk. The creditworthiness of the issuing company, which assesses the issuer’s ability to timely pay back its debt, largely determines the bond’s yield and risk level.

Companies with strong credit ratings issue investment-grade corporate bonds.

Companies with lower credit ratings issue high-yield bonds, which offer higher income and return potential but also higher default risk. Investors in high-yield bonds should prepare for potential price volatility and credit risk.

All bonds come with interest rate and reinvestment risks. Investors can’t eliminate the risks, but they can seek to mitigate them.

How Call and Put Provisions Affect Income Potential

Some bonds are “callable.” A call provision grants the bond issuer the power to redeem the bond before the stated maturity date. If that happens, the issuer would pay you the call price and any accrued interest, but it wouldn’t make any future interest payments.

Additionally, some bonds are “putable.” A put bond gives the bondholder the option to redeem the bond before the maturity date.

A call provision can reduce a bond's perceived value because it potentially limits the bondholder's coupon payments and price appreciation potential.

A put provision may increase the bond's perceived value because it gives the bondholder the power to redeem the bond and potentially avoid price depreciation.

Factors Influencing Bond Income

Several factors can influence the income you earn from bonds:

1. Market interest rates: When interest rates rise, bond prices fall, and vice versa. This inverse relationship affects the yield and overall return potential. For example, suppose you hold a bond with a 4% coupon and market interest rates rise to 5%. The issuer’s new bonds will feature a higher coupon, making your bond less attractive and pushing its price lower.

2. Credit risk: Higher credit risk typically means higher coupon rates to potentially compensate for higher default risk. It’s important to assess a bond's credit rating before investing to understand the level of risk involved.

3. Tax implications: Some bonds, like municipal bonds, may offer tax advantages that can enhance your after-tax income.

4. Inflation: Higher inflation can erode the purchasing power of your bond’s interest payments and principal repayment. If inflation rises, the money you earn from your bonds will be worth less in real terms.

As inflation expectations rise, investors demand higher yields across the yield curve to compensate for the loss of purchasing power. Bonds with longer maturities are more sensitive to rising inflation because people are locking up their money for longer periods of time.

Bonds and Income: A Match Made in … Retirement

Many investors scale back on stocks and add bonds as they approach retirement age. Why? Bonds’ regular interest payments can help convert a retirement nest egg to a stream of income. Stocks might provide better return potential (along with a higher risk of losses, of course), but most don’t provide income the same way a bond can.

What's more, higher-quality bonds can also help you hedge against market risk from the remaining stocks in your portfolio. And investors in a high tax bracket in retirement may want the tax-free income potential of municipal bonds.

Professionally Managed Multi-Asset Portfolios

Bonds are not the only income-generating securities available to investors. You can also consider a diversified portfolio managed by professionals knowledgeable about the multiple risks investors face. Call us to find out more about our multi-asset income solutions.^**