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One of the key tenets of building a strong portfolio is diversification—investing in different types of assets in order to mitigate risk and see steady long-term growth.

Besides stocks, bonds are a popular asset class which is considered one of the most secure investments one can make. When the stock market is headed for a storm, the bond market can act as a safe haven. Although people talk about stocks a lot more, the bond market is actually quite a bit larger. In 2020 the market cap of the global bond market was about $160 trillion, while the market cap of the stock market was $95 trillion.

The bond market has a long history. The first bonds were issued in the late 1600s by the Bank of England to help raise funds to fight a war against France. Since then, the global bond market has continued to grow and flourish.

So, what exactly is a bond and how does the bond market work?

Why the Bond Market Exists

Just as individuals need to take out loans in order to buy a home or pay for other expenses, governments, cities, and companies also need to borrow money. They can do this by selling bonds, a form of structured debt, and paying a specified amount of interest on them over time.

Essentially a bond is an interest-bearing IOU. An institution might need to borrow millions of dollars, but individuals are able to lend them a small amount of that total loan by purchasing bonds. The reason an institution would choose to issue bonds instead of borrowing money from a bank is that they can get better interest rates with bonds.

Bonds are issued for a specific length of time, called the “term to maturity.” A fixed amount of interest gets paid to the investor every six months or year, and the principal investment gets paid back at the end of the loan period, on what is called the maturity date. In some cases, the interest is paid in a lump sum on the maturity date along with the principal investment funds.

Recommended: How Do Bonds Work?

For example, an investor could buy a $10,000 bond from a city, with a 10-year term that pays 2% interest. The city agrees to pay the investor $200 in interest every six months for the 10 year period, and will pay back the $10,000 at the end of the 10 years.

Bonds are generally issued when a government or corporation needs money for a specific purpose, such as making capital improvements or acquiring another business.

Primary vs Secondary Bond Markets

Bonds are sold in two different markets: the primary market and the secondary market. Newly issued bonds are sold on the primary market, where sales happen directly between issuers and investors. Investors who purchase bonds may then choose to sell them before they reach maturity, using the secondary market. One may also choose to purchase bonds in the secondary market rather than only buying new issue bonds.

Bonds in the secondary market are priced based on their interest rate, their maturity date, and their bond rating, (more on that below). Notes with higher interest rates and more years left until maturity are worth more than those with low rates and those that are nearing maturity.

Differences in Bonds

Bond terms and features vary depending on the type and who issues them. The main types of bonds are:

US Treasury Bills

These government-issued short-term bonds are the safest, but pay the least interest. The sale of treasuries funds all government functions. These bonds are subject to federal income taxes, but are exempt from local and state income taxes.

Recommended: How to Buy Treasury Bills, Bonds, and Notes

Longer-Term Treasury Bills

Bonds such as the 10-year note are the next safest option and pay a slightly higher interest rate.

Treasury Inflation Protected Securities (TIPS)

These bonds specifically protect against inflation, so they pay out a higher interest rate than the rate of inflation.

Municipal Bonds

Also known as muni bonds, these bonds are issued by cities and towns. They are somewhat riskier than treasury bills but offer higher returns. Muni bonds are exempt from federal taxes, and often state taxes as well.

Agency Bonds

Agency bonds are sold to fund federal agriculture, education, and mortgage lending programs. They are sold by Government Sponsored Enterprise (GSE) including Freddie Mac and Fannie Mae.

Corporate Bonds

The riskiest bond types are those issued by companies. The reason they have more risk is that companies can’t raise taxes to pay back their debts, and companies always have some risk of failure. The interest rate on corporate bonds depends on the company. These bonds typically have a maturity of at least one year, and they are subject to federal and state income taxes.

Junk Bonds

Corporate bonds with the highest risk and highest potential return are called junk bonds or high yield bonds. All bonds get rated from a high of AAA down to junk bonds—more on bond ratings below.

Convertible Bonds

Corporate bonds that can be converted into stock at certain times throughout the term of the bond.

Mortgage-Backed Bonds

These bonds consist of pooled mortgages on real estate.

Foreign Bonds

Similar to US bonds, investors can also purchase bonds issued in other countries. These carry the additional risk of currency fluctuations.

Emerging Market Bonds

Companies and governments in emerging markets issue bonds to help with continued economic growth. These bonds have potential for growth but can also be riskier than investing in developed market economies.

Zero Coupon Bonds

Zero coupon bonds don’t pay interest, but are sold at a great discount. Some bonds get transformed into zero coupon bonds, while others start out as zero coupon bonds. Investors earn a profit when the bond reaches maturity because it will have increased in value, and they receive the face value of the bond at the maturity date.

Bond Funds

Investors can also buy into bond funds or bond ETFs, which are groups of different types of bonds collected into a single fund. There are bond funds that group together corporate bonds, junk bonds, and other types of bonds. These funds are managed by a fund manager. Bond funds are safer than individual bonds, since they diversify money into many different bonds.

Bond Indices

Similar to a stock index, there are bond indices that track the performance of groups of bonds. Examples of bond indices include the Merrill Lynch Domestic Master, the Citigroup US Broad Investment-Grade Bond Index, and the Barclays Capital Aggregate Bond Index.

What to Look at When Choosing Bonds

When investors are looking into stocks to invest in, the differences are mainly in the prospects of the company, the team, and the company’s products and services. Stock shares themselves tend to be pretty similar. Bonds, on the other hand, can have significantly different terms and features. For this reason, it’s important for investors to have some understanding of how bonds work before they begin to invest in them.

The main features to look at when selecting bonds are:

Maturity

The maturity date tells an investor the length of the bond term. This helps the buyer know how long their money will be tied up in the bond investment. Also, bonds tend to decrease in value as they near their maturity date, so if a buyer is looking at the secondary market it’s important to pay attention to the maturity date. Bond maturity dates fall into three categories:

•   Short term: Bonds that mature within 1-3 years.
•   Medium-term: Bonds that mature around ten years.
•   Long-term: These bonds could take up to 30 years to mature.

Secured vs. Unsecured

Secured bonds promise that specific assets will be transferred to bondholders if the corporation is unable to repay the bond loan. One type of secured bond is a mortgage-backed security, which is secured with real estate collateral.

Unsecured bonds, also known as debentures, are not backed by any assets, so if the company defaults on the loan the investor loses their money. Both have their benefits and disadvantages, so it is a good idea to understand the difference between secured and unsecured bonds.

Yield

This is the total return rate of the bond. Although a bond’s interest rate is fixed, its yield fluctuates since the price of the bond changes based on market fluctuations. There are a few different ways yield can be measured:

•   Yield to Maturity (YTM): YTM is the most commonly used yield measurement. It refers to the total return of a bond if all interest gets paid and it is held until its maturity date. YTM assumes that interest earned on the bond gets reinvested at the same rate of the bond, which is unlikely to actually happen, so the actual return will differ somewhat from the YTM.
•   Current Yield: This calculation can help bondholders compare the return they are getting on a bond to the dividend return they receive from a stock. It looks at the bond’s current market price and the amount of interest earned on that bond.
•   Nominal Yield: This is the percentage of interest that gets paid out on the bond within a certain period of time. Since the current value of a bond changes over time, but the nominal yield calculation is based on the bond’s face value, the nominal yield isn’t entirely accurate.
•   Yield to Call (YTC): Some bonds may be called before they reach maturity. Bondholders can use the YTC calculation to estimate what their earnings will be if the bond gets called.
•   Realized Yield: This is a calculation used if a bondholder plans to sell a bond in the secondary market at a particular time. It tells them how much they will earn on the bond between the time of the purchase and the time of sale.

Price

This is the value of a bond in the secondary market. There are two bond prices in the secondary market: bidding price and asking price. The bidding price is the highest amount a buyer is willing to pay for a specific bond, and the asking price is the lowest price a bondholder would be willing to sell the bond for. Bond prices change as market interest rates change, along with other factors.

Recommended: What Is Bond Valuation and How Do You Calculate It?

Rating

As mentioned above, all bonds and bond issuers are rated by bond rating agencies. The rating of a bond helps investors understand the risk and potential earnings associated with a bond. Bonds and bond issuers with lower ratings have a higher risk of default.

Ratings are done by three bond rating agencies: Standard & Poor’s, Moody’s, and Fitch. Fitch and Standard & Poor’s rate bonds from AAA down to D, while Moody’s rates from Aaa to C.

Bond Market Terminology

When buying bonds, there are several terms which investors may not be familiar with. Some of the key terms to know include:

•   Liquidation Preference: If a company goes bankrupt, investors get paid back in a specific order as the company sells off assets. Depending on the type of investment, an investor may or may not get their money back. Companies pay back “Senior Debt” first, followed by “Junior Debt.”
•   Coupon: This is the fixed dollar amount paid to investors. For example, if an investor buys a $1000 bond with a 3% interest rate, and interest gets paid out annually, the coupon rate is $30/year.
•   Face Value: Also referred to as “par,” this is the price of the bond when it reaches maturity. Usually bonds have a starting face value of $1,000. If a bond sells in the secondary market for higher than its face value, this is known as “trading at a premium,” while bonds that sell below face value are “trading at a discount.”
•   Duration Risk: This is a calculation of how much a bond’s value may fluctuate when interest rates change. Longer term bonds are at more risk of value fluctuations.
•   Puttable Bonds: Some bonds allow the bondholder to redeem their principal investment before the maturity date, at specific times during the bond term.

The Bond Market and Stocks

Although there is no direct correlation between the bond market and the stock market, the performance of the secondary bond market often reflects people’s perceptions of the stock market and the overall economy.

When investors feel good about the stock market, they are less likely to buy bonds, since bonds provide lower returns and require long-term investment. But when there’s a negative outlook for the stock market, investors want to put their money into safer assets, such as bonds.

How to Make Money on Bonds

While the most obvious way to make money on bonds is to hold them until their maturity to receive the principal investment plus interest, there is also another way investors can make money on bonds.

As mentioned above, bonds can be sold on the secondary market any time before their maturity date. If an investor sells a bond for more than they paid for it, they make a profit.

There are two reasons the price of a bond might increase. If newly issued bonds come out with lower interest rates, then bonds that had been previously issued with higher interest rates go up in value. Or, if the credit risk profile of the government or corporation that issued the bonds improves, that means the institution will be more likely to be able to repay the bond, so its value increases.

Advantages of Bonds

There are several reasons that bonds are a good investment, and they have some advantages over stocks and other assets.

•   Predictable Income: Since bonds are sold with a fixed interest rate, investors know exactly how much they will earn from the investment.
•   Security: Bonds are considered to be a much safer investment than stocks. Although they offer lower interest rates than most stocks, they don’t have the volatility and risk.
•   Contribution: The funds raised from the sale of bonds may go towards improving cities, towns, and other community features. By investing in bonds, one is supporting community improvements.
•   Diversification: Bonds can be a great addition to an investment portfolio because they provide diversification away from stocks. Building a diversified portfolio is key to long-term growth.
•   Obligation: There is no guarantee of payment when investing in stocks. Bonds are a debt obligation that the issuer has agreed to pay.
Profit on Resale: Investors have the opportunity to resell their bonds in the secondary market and make a profit.

Disadvantages of Bonds

Although there are many upsides to investing in bonds, they also have some risks and downsides. Like any investment, it’s important to do research before buying.

•   Lack of Liquidity: Investors can sell bonds before their maturity date, but they may not be able to sell them at the same or higher price than they bought them for. If they hold on to the bond until its maturity, that cash isn’t available for use for a long period of time.
Bond Issuer Default and Credit Risk: Bonds are fairly secure, but there is a possibility that the issuer won’t be able to pay back the loan. If this happens, the investor may not receive their principal or interest.
•   Low Returns: Bonds offer fairly low interest rates, so in the long run investors are likely to see greater returns in the stock market. In some cases, the bond rate may even be lower than the rate of inflation.
•   Market Changes: Bonds can decrease in value if the issuing corporation’s bond rating changes, if the company’s prospects don’t look good, or it looks like they may ultimately default on the loan.
•   Interest Rate Changes: One of the most important things to understand about bonds is that their value has an inverse relationship with interest rates. If interest rates increase, the value of bonds decreases, and vice versa. The reason for this is that if interest rates rise on new bond issues, investors would prefer to own those bonds than older bonds with lower rates. If a bond is close to reaching maturity it will be less affected by changing interest rates than a bond that still has many years left to mature.
•   Not FDIC Insured: There is no FDIC insurance for bondholders. If the issuer defaults, the investor loses the money they invested.
•   Call Provision: Sometimes corporations have the option to redeem bonds. This isn’t a major downside, but does mean investors receive their money back and will be able to reinvest it.

How to Buy Bonds

Bonds differ from stocks in that they aren’t traded publicly. Investors must go through a broker to purchase most bonds, or they can buy US Treasury bonds directly from the government.

Brokers can sell bonds at any price, so it’s important for investors to research to make sure they are getting a good price. They can also check the Financial Industry Regulatory Authority (FINRA) to see benchmark data and get an idea about how much they should be paying for a particular bond. FINRA also has a search tool for investors to find credible bond brokers.

As mentioned above, traders can either buy bonds in the primary or secondary market, or they can buy into bond mutual funds and bond ETFs.

Get Started Buying Bonds

For those looking to start investing in bonds, stocks, and other assets, there are many great tools available to help. One easy way to start buying into the bond market is using SoFi Invest’s® online investment tools. SoFi has an easy-to-use app investors can use to buy and sell bond funds with a few clicks of a button and keep track of their favorite bond funds and stocks, research specific assets, and set personalized financial goals.

Buying into bond funds is a good way for investors to gain exposure to a diversified portfolio of bonds, rather than going through the complex process of choosing individual bonds.

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Investment Risk: Diversification can help reduce some investment risk. It cannot guarantee profit, or fully protect in a down market.

Insider trading is illegal trading in financial markets using confidential (or “insider”) information to the investor’s own advantage—and it can be a criminal offense in the investments market.

Trading specialists have outlined the term “confidential information” as material information about an investment vehicle (like a stock) that is not available to other investors. That insider knowledge can tilt the playing field in favor of the recipient, leading to an imbalanced trading landscape that investment industry regulators rigorously attempt to keep fair and balanced.

History of U.S. Insider Trading Laws

Insider trading rules and regulations in the U.S. date back to the early 1900s, when the U.S Supreme Court ruled against a corporate executive who bought company stock based on insider information. The ruling, based on common law statutes long used by the United Kingdom, laid the path for Congress to pass a law prohibiting sales security fraud (the 1933 Securities Act of 1933) that was further solidified by the Securities Exchange Act of 1934.

Those laws not only prohibited the profit of securities invested tied to insider information, they also largely blocked quick turnaround trading profits by an investor who owned more than 10 percent of a company stock.

Fast forward to 1984, when Congress passed the Trading Sanctions Act, and 1988, and the passage of the Securities Fraud Enforcement Act of 1988, which set financial penalties of three times the amount of income accumulated from insider trading, further clarifying the definition and rules surrounding insider trading.

Examples of Insider Trading

Despite the blanket term of “insider trading”, the practice can manifest itself in myriad ways. Broadly, anyone at all who steals, misappropriates, or otherwise gathers confidential data or information, and uses it to profit on changes in a company’s stock price, might be investigated for insider trading.

Here are some common examples:

•  A company executive, employee, or board member who trades a corporation’s stock after being made aware of a particular business development could be engaging in insider trading. “Insider” developments like the sale of the firm, positive or negative earnings numbers, a company scandal or significant data breach, or other piece of information that would likely sway the company’s stock price could be construed by regulators as insider trading.
•  Any associates—like friends, family, or co-workers—of the above execs employees, or board members, who also trade on private information not available to the investing public, may be targeted for insider trading.
•  Executives and staffers of any company that provided products or services to a company that obtains information about a significant corporate move that would likely sway the firm’s stock price could be trading on “inside” news. Think of a bank, brokerage firm, or printing company that might have knowledge of company news before it is released to the investing public, and who uses that knowledge to profit from the information.
•  Local, city, state, or federal government managers and employees who may come across sensitive and private information on a company that’s not available publicly, and use that knowledge to profit from a change in the company’s stock price, could be involved with insider trading.

The above examples are among the most egregious insider trading scenarios, and are also more likely to become an enforcement priority for government regulators.

Is Insider Trading Ever Legal?

There are scenarios where what is technically considered “insider trading” is in fact legal under federal regulatory statutes.

For instance, anyone employed by a company falls under the definition of an insider trader. But as long as all stock transactions involving the company are registered with the U.S. Securities and Exchange Commission in advance, any employee stock transaction is perfectly legal.

That’s the case whether a rank-and-file employee buys 100 shares of company stock or if the chief executive officer buys back shares of the firm’s stock—even if that more high-profile trading activity significantly swings the company’s share price.

Who Enforces Insider Trading Rules?

Insider trading enforcement measures operate under the larger umbrella of the U.S. government.

Like any criminal case, the sequence of enforcement events may begin with an investigation, a review of the investigation’s results by government regulators, an arrest and arraignment, a court case in front of a judge, and incarceration in the penal system (or regular review by a probation officer if the charge results in a more lenient sentence).

How Insider Trading is Investigated

Insider trading investigations usually start on the firm level before the SEC gets involved. Self-regulating industry organizations like the Financial Industry Regulatory Authority (FINRA) or the National Association of Financial Planners (NAPF), for example, may also come across illegal trading practices and pass the lead on to federal authorities.

It’s also not uncommon for insider trading practices to be revealed by government agencies other than the SEC. For example, the FBI may run into insider trading activity while pursuing a completely separate investigation, and pass on the tip to the SEC.

When the U.S. Securities and Exchange Commission (SEC) investigates potential insider trading cases, they do so using multiple investigatory methods:

Surveillance. The SEC has multiple surveillance tools to root out insider trading violations. Tracking big variations in a company’s trading history (especially around key dates like earnings calls, changes in executive leadership, and when a company buys another firm or is bought out itself) is a common way for federal regulators to uncover insider trading.

Tipsters. Investors aware of insider information, especially those who lose money on insider trades, often provide valuable leads and tips on insider trading occurrences. This often occurs in the equity options market, where trade values increase significantly with each transaction, and where stock prices can especially be vulnerable to big price swings after suspicious trading activity in the stock options marketplace.

If, for example, a trader with inside information uses it to buy company stock or to buy an option call for profit, the party on the other side of the trade, who may stand to lose significant cash on the trade, may alert the SEC that profiteering via inside information may be taking place. In that scenario, the SEC will likely appoint an investigator to follow up on the tip and see if insider trading did occur.

Company whistleblowers. Another common alert that insider trading is occurring comes from company whistleblowers who speak up when company employees or managers with unique access to company trading patterns seem to be benefitting from those price swings.

What Happens in an Insider Trading Investigation

When federal regulators are made aware of securities fraud from insider trading, they may launch an investigation run by the SEC’s Division of Enforcement. In that investigation . . .

•  Witnesses are contacted and interviewed.
•  Trading records are reviewed, with a close eye on trading patterns around the time of potential insider trading activity.
•  Phone and computer records are subpoenaed, and if needed, wiretaps are used to gain information from potential insider trading targets.
•  Once the investigation is complete, the investigation team presents its findings to an SEC review board, which can decide on a fine and other penalties (like suspension of trading privileges and cease-and-desist orders) or opt to take its case to federal court.
•  After the court hears the case and decides on the merits, any party accused of insider trading is expected to abide by the court ruling and the case is ended.

Penalties for Insider Trading

An individual convicted of insider trading can face both a prison sentence and civil and criminal fines—up to 20 years and as much as $5 million. Additionally, civil penalties may include fines of up to three times the profit gained or loss avoided as a result of the insider trading violation.

Companies that commit insider trading can face civil and criminal fines. The maximum fine for an entity whose securities are publicly traded that has been found guilty of insider trading is $25 million.

The Takeaway

Insider trading—executing a trade based on knowledge that has not been made public—is a serious offense and can lead to severe punishment, including jail time and heavy fines.

That’s all for good reason, as restrictions on insider trading help ensure a balanced financial trading market environment—one that accommodates fair trading opportunities for all market participants.

Investing shouldn’t be complicated. SoFi Invest® online trading accounts offer an active investing solution that allow members to choose assets such as stocks and ETFs, as well as an automated investing solution that invests around your goals and risk.

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