What is a bond and how does it work?

How Bonds Are Traded and How They Generate Returns

Unlike a traditional loan that usually remains between the lender and borrower until it is repaid, bonds can be traded after they are issued. Once a bond is created in the primary market, investors are able to buy and sell it with other market participants in what is known as the secondary market.

For most retail investors, bond transactions take place in the secondary market through a brokerage account. This applies to both government bonds and bonds issued by corporations.

To illustrate how bonds function, imagine investing $10,000 in a ten-year bond that offers a 2% annual yield. In this case, you are effectively lending $10,000 to the issuer—whether it is a government or a company—for a ten-year period. In return, you would receive $200 in interest each year, provided you keep the bond until it reaches maturity.

Because bonds are actively traded in secondary markets, you are not required to hold them until maturity. Investors can sell their bonds before the end of the term at the current market price. The amount received from the sale will generally include any interest that has accumulated up to that point.

What Else Should You Know About Bonds?

If you want to gain a deeper understanding before determining the ideal bond allocation for your portfolio, exploring additional educational resources and articles on bond investing can help expand your knowledge.