Key takeaways
- A bond pays fixed coupons and returns face value at maturity, if the issuer pays.
- Prices move opposite to yields; duration estimates the size of the move.
- Yield to maturity is the best single yardstick for comparing bonds.
- Extra yield usually pays for extra credit, duration or liquidity risk.
- Bond funds never mature, so judge them by duration and credit quality.
A bond is a loan you make to a government or company in exchange for regular interest and the promise of your money back on a set date. That sounds dull and predictable, and the cash flows are. The price you can sell at before maturity is not, and that gap trips up many first-time bond buyers.
The anatomy of a bond
Every bond comes with a few fixed terms. Knowing them lets you read any bond listing.
| Term | Meaning | Example |
|---|---|---|
| Face value (par) | The amount repaid at maturity | 1,000 |
| Coupon | The yearly interest, as a percentage of face value | 4% means 40 a year |
| Maturity | The date the principal is repaid | Ten years from issue |
| Issuer | Who owes you the money | A government or a company |
| Price | What the market will pay today, quoted per 100 of face value | 95 means 950 for a 1,000 bond |
Coupons are fixed at issue for most conventional bonds. The market price moves around every day, which is what makes yields change.
Three kinds of yield
Yield tells you what you earn relative to the price paid. Several versions exist, and they answer different questions.
- Coupon rate: the interest set in the contract, relative to face value. It never changes.
- Current yield: yearly coupon divided by today's price. A 1,000 bond with a 4% coupon (40) bought at 950 has a current yield of about 4.2%.
- Yield to maturity: the annual return if you buy now, collect every coupon and hold until repayment. It also counts the gain from buying below par and repaid at 1,000, so here it would be higher than 4.2%.
When comparing bonds, yield to maturity is usually the fairest like-for-like figure. It assumes the issuer pays in full and that you can reinvest coupons at the same rate, so treat it as a guide, not a promise.
Why bond prices fall when rates rise
Suppose you own a bond paying a 4% coupon. If new bonds start paying 5%, nobody will pay full price for your 4% bond. Its price has to fall until its yield looks competitive. The reverse also holds: when rates drop, older higher-coupon bonds become more valuable.
Hold the bond to maturity and, if the issuer pays, you get the face value back regardless of the interim wobble. Sell early and the market price is what you receive. That is the core of interest-rate risk.
Duration: a ruler for rate sensitivity
Duration estimates how much a bond's price moves for a one percentage point change in yields. A rough rule: a duration of 7 means about a 7% fall in price if yields rise by one point, and about a 7% rise if they fall one point. Longer maturities and lower coupons mean longer duration and bigger swings.
Illustrative rule-of-thumb figures; real prices also depend on convexity and other factors.
This is why long-term government bonds, widely considered very low in default risk, can still lose double-digit percentages in a period of sharply rising rates.
Credit risk: will the issuer pay?
Credit risk is the chance the issuer misses payments or restructures. Rating agencies grade issuers on letter scales. There is a dividing line between investment grade (lower default risk) and high yield, sometimes called speculative or junk (higher risk). Higher-risk borrowers pay higher coupons to attract lenders, so extra yield is the market's price for extra danger rather than free money.
| Risk | What it is | What drives it |
|---|---|---|
| Interest-rate risk | Price falls when yields rise | Central bank policy, inflation expectations, duration |
| Credit risk | Issuer fails to pay in full or on time | Issuer finances, economy, rating changes |
| Inflation risk | Fixed payments buy less over time | Rising prices |
| Liquidity risk | Hard to sell at a fair price | Small issues, stressed markets |
| Call risk | Issuer repays early when rates drop | Features in the bond terms |
Individual bonds or a bond fund?
With an individual bond held to maturity, you know the schedule of payments and the end date. With a bond fund, the portfolio constantly rolls: bonds mature and are replaced, so there is no fixed end date and the price can stay below your purchase for long stretches if rates remain high.
How to approach a first bond purchase
- Define the job. Is the money meant to dampen volatility, generate income or be spent on a known date? Each answer points to different maturities.
- Match duration to horizon. If you need the cash in three years, a very long bond adds rate risk you may not want.Tip: Matching duration to your horizon is a classic way to reduce surprises.
- Check the issuer. Look at the rating, the issuer's finances and what happens in default.
- Read the costs. Bond spreads can be wide, especially on small issues, and funds charge annual fees. Both reduce yield.
- Diversify issuers. Avoid putting everything in one corporate name.
Frequently asked questions
Are bonds safer than stocks?
Generally they have been less volatile, but safety depends on the issuer and duration. Long bonds and weak issuers can lose a lot.
Can I lose money on a government bond?
Yes, if you sell before maturity after yields have risen, and in real terms if inflation exceeds the yield. Default is a separate risk that varies by country.
What does 'investment grade' mean?
It is a rating category indicating a relatively lower chance of default. It is an opinion, not a guarantee, and ratings change.
Why might a bond index fund hold lots of debt from heavy borrowers?
Many bond indices weight issuers by the amount of debt outstanding, so the biggest borrowers can get the biggest weights. That is a feature of the index method and worth knowing before you buy.