Bonds are income-bearing investments that trade freely in the open markets. This sets them apart from other types of investments, such as bank certificates of deposit, which trigger a penalty for being sold early. Although you're able to sell a bond anytime there's a willing buyer, many bondholders wait until the bond matures to give it up. Selling a bond before maturity doesn't generate a penalty per se, but there can be costs to doing so.
Loss on Principal
Bonds are often thought of as more conservative than stocks because bond issuers guarantee the return of your principal at maturity. If you sell a bond early, however, that guarantee doesn't apply. Between the time a bond is issued and the day it matures, its price is subject to outside market factors. Interest rates, in particular, affect how a bond trades. When rates rise, bond prices fall. If you can hang on until maturity, you'll get back $1,000 per bond in most cases. Sell a bond early, and you'll only get the price that's available in the market.
Loss on Interest
Most bonds pay interest twice per year until maturity. If you sell a bond early, you no longer own the right to those interest payments. The buyer who takes the bond off your hands inherits the right to all future income. Things get worse if market interest rates have fallen since you bought the bond. If you want to reinvest your money, you'll end up earning a lower rate than the bond you just sold. Whether you reinvest your proceeds or keep the cash in your pocket, you'll end up with less interest going forward.
Capital Gains Tax
If you sell a bond early, it's entirely possible you'll generate a gain on the sale. Just like bond prices fall when interest rates rise, bond prices go up when interest rates fall. While taking a gain is generally a good thing, if you sell your bond at a profit, it will trigger capital gains tax. Long-term gains, or those held longer than one year, do benefit from the reduced capital gains tax rate. However, if you've held your bond for one year or less, things only get worse from a tax perspective. You'll have to pay ordinary income tax on your profit, which from a federal perspective alone could reach 39.6 percent as of 2013.
When you sell your bond, you'll usually have to pay a fee for the service. Brokers charge a commission, or "markdown," which reduces the price you receive for your bond. This charge isn't strictly a penalty because it can vary from bond to bond and from broker to broker. However, the effect is the same -- you'll end up with less money if you sell your bond early, as it doesn't cost anything at all to let your bond mature.
John Csiszar has written thousands of articles on financial services based on his extensive experience in the industry. Csiszar earned a Certified Financial Planner designation and served for 18 years as an investment counselor before becoming a writing and editing contractor for various private clients. In addition to his online work, he has published five educational books for young adults.