Bonds are debt securities where you lend money to an issuer (such as a government or corporation) in exchange for regular interest payments and the return of the principal amount at maturity. To invest in bonds, decide on your investment goals, choose between individual bonds or bond funds, evaluate the bond’s credit rating and terms, buy through a broker or directly from the issuer, and manage your investment based on interest rates and market conditions.

What is a bond? A bond is a way of borrowing money (and paying interest) or lending money (and receiving interest). You earn interest by buying bonds and you pay interest by issuing bonds. Typically a bond is issued by an institution such as a government agency or a business that needs a lot of money. When the bond is issued by a town or city or state, or certain other organizations that serve the public, such as a school district or water district, it is called a municipal bond. Municipal bonds have a special advantage - the interest you receive may be free of federal income tax. On the other hand, such tax free bonds typically pay lower interest rates than bonds issued by a business, for example, so the tax free benefit is mostly of interest to people in high income tax brackets.

Here’s an example. Suppose your town needs a new fire station and it will cost $10,000,000. Such a fire station would normally be paid for by property taxes - from the citizens of the town who would benefit from the fire station in the event of a fire. Let’s say that the town has 500 separate real estate properties, 100 large ones owned by companies or landlords of apartment buildings and 400 small ones owned by individual homeowners. To pay for the new fire station the town’s government might decide to charge each large property owner $84,000 and each homeowner $4000. This is in addition to what they might normally pay in property tax. But of course nobody wants to pay that much extra in their property tax bill. So the town issues bonds.

The town issues $10,000,000 worth of bonds, paying perhaps 3% interest for 30 years. To pay off those bonds, each homeowner will have their property tax bill raised by about $140 per year, and each large property owner will have their property tax bill raised by about $3000 per year. [My math here is inexact, but the general idea is correct.] These higher tax bills will go on for 30 years, but most people would rather pay an extra $140 per year than pay $4000 extra in one year. This is a good deal for all. The taxpayers pay a little extra per year and get a new fire station. The people who buy the bonds get 30 years worth of interest and then get their money back. Bonds are how most towns and cities pay for a lot of things that are very expensive but last a long time. Roads, fire stations, courthouses, schools, and many other things are paid for by bonds, so the individual taxpayers don’t get hit with huge property tax increases to pay for those things all at once.

It’s all similar to a home mortgage, except that the borrower is the town and the repayment comes from the taxpayers (property holders) living in the town. Each bond is purchased for a certain amount, typically $1000, and in return the purchaser gets interest every year (in this example, $30), and after 30 years (when it is said that the bond as reached maturity) they get their $1000 back. A retiree might buy $100,000 worth of bonds in order to get income of $3000 per year for 30 years.

Bonds are frequently bought for retirement funds or other purposes where a reliable source of fixed income over a long time period is desired. They don’t fluctuate in value like stocks, and that consistency is often highly desirable. So how do you buy bonds? There are many ways, but here are the two most popular ways:

Bond mutual funds There are quite a few mutual funds specializing in bonds. You buy shares of the mutual fund and receive your share of the interest paid by the bonds held in the fund. There are many varieties but the gist is that the bond manager buys millions of dollars worth of bonds each year from a great variety of sources, using funds supplied by the purchasers of bond mutual fund shares. The interest paid by those bonds is paid back to the bond fund shareholders, less a small amount used to pay the fund’s expenses, such as the salaries for its managers. In exchange for a slightly lower amount of interest, the bond fund purchaser gets the services of the bond fund managers, who decide which bonds to purchase or sell.

The managers also carry out the actual purchases and sales, and handle all the administrative work. And because they buy the bonds from thousands of different places, they get the benefit of diversification. That means if any one of the bond issuers has financial trouble and cannot pay the interest on its bonds, the bond fund investor barely notices any difference. Another benefit of bond funds is that it is easy to buy in or sell out at any time. You don’t have to wait 30 years.

Individual bonds You can buy individual bonds from the bond issuers directly (for example, the town might offer bonds to its citizens) or you can buy them through investment companies such as Fidelity or Vanguard or Schwab. You can also sell them through investment companies. Or you could sell one to your aunt Mabel, if she wants to buy one. You get a slightly higher interest payment with an individual bond, compared with buying shares of a bond mutual fund, but there’s a bit more work on your part. However the major drawback of buying individual bonds is the risk of default. If your town is hit by a major disaster and cannot afford to pay interest on its bonds for several years, you may be stuck with bonds that pay no interest.

Note that if you buy an individual bond you can also sell it on the bond market (or buy bonds on the bond market). There is an active market for buying and selling bonds like this. For example, if you buy a 30 year bond but decide you need your money after 10 years, you can sell your bond. There’s another category of bonds that is very popular - US Treasuries. These are bonds issued by the US government. Like municipal bonds, you can buy and sell them through investment companies and you can buy bond mutual funds specializing in US government bonds. But you can also buy individual bonds through an organization called Treasury Direct, or you can go to your bank and buy savings bonds.