Bond

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Bonds: How They Work and How to Invest

Key takeaways

  • A bond is a fixed-income instrument: you lend money to a government or company in exchange for periodic interest (coupon) and repayment of principal at maturity.
  • Bond prices move inversely to interest rates: when rates rise, bond prices fall; when rates fall, bond prices rise.
  • Bonds vary by issuer, credit quality, maturity and special features (callable, convertible, zero-coupon). You can buy them directly or via funds/ETFs.

What is a bond?

A bond is a debt security issued by a government, municipality, agency or corporation to raise capital. Bondholders are creditors of the issuer. The issuer agrees to pay interest (the coupon) and return the bond’s face value (par) at a specified maturity date.

Main bond features

  • Face value (par): amount repaid at maturity (commonly $1,000 for corporate bonds).
  • Coupon rate: annual interest paid on the face value, expressed as a percentage.
  • Coupon dates: when interest payments are made (e.g., semiannual).
  • Maturity date: when the principal is repaid.
  • Issue price: the price at which the bond is originally sold (often at par).

Categories of bonds

  • Government (Treasuries): U.S. Treasuries include bills (≤1 year), notes (1–10 years) and bonds (>10 years).
  • Agency bonds: issued by government-sponsored entities (e.g., Fannie Mae, Freddie Mac).
  • Municipal bonds: issued by states or localities; some offer tax-exempt interest.
  • Corporate bonds: issued by companies; terms and credit risk vary widely.
  • Foreign/sovereign bonds: issued by other countries or foreign corporations.

How bond prices relate to interest rates

Bond market prices adjust so that a bond’s yield matches prevailing market rates. If market rates fall below a bond’s coupon, the bond trades at a premium; if rates rise above the coupon, it trades at a discount. This inverse relationship is the core driver of bond price volatility.

Example (intuition): a $1,000 bond paying $100 per year (10% coupon) looks less attractive if new bonds pay 5%—investors bid the price up so the $100 represents about a 5% yield.

Yield-to-maturity (YTM) and duration

  • Yield-to-maturity (YTM): the annualized internal rate of return if you hold the bond to maturity and all payments occur as scheduled. YTM allows comparison across bonds with different coupons and maturities.
  • Duration: a measure of interest-rate sensitivity. Modified duration estimates the percentage price change for a 1 percentage-point change in yields. Longer maturities and lower coupons generally produce higher duration and higher sensitivity to rate moves.

Common bond variations

  • Zero-coupon bonds: issued at a discount and pay no periodic interest; return is the difference between purchase price and par at maturity.
  • Convertible bonds: can be converted into the issuer’s equity under specified terms.
  • Callable bonds: issuer can redeem the bond before maturity; adds reinvestment/call risk for investors.
  • Puttable bonds: allow the holder to sell the bond back to the issuer before maturity; provides downside protection.

What determines a bond’s coupon and rating

  • Coupon drivers: issuer credit quality (higher risk → higher coupon) and time to maturity (longer maturities usually pay more to compensate for inflation and rate risk).
  • Credit ratings: agencies (S&P, Moody’s, Fitch) assess issuer default risk. “Investment grade” indicates higher credit quality; below that are “high yield” or “junk” bonds, which pay higher coupons to compensate for greater default risk.

Major risks

  • Interest-rate risk: price sensitivity to changes in market rates.
  • Credit/default risk: risk the issuer fails to make payments.
  • Inflation risk: inflation erodes real returns.
  • Call risk: issuer may redeem callable bonds when rates fall.
  • Reinvestment risk: coupons received may be reinvested at lower rates.
  • Liquidity risk: some bonds are harder to buy or sell without price concessions.

How to invest in bonds

  • Direct purchase: through brokers or bond desks; U.S. Treasuries can be bought via TreasuryDirect.
  • Bond funds and ETFs: provide diversified exposure and ease of trading; however, fund share prices fluctuate and you don’t hold individual bonds to maturity.
  • Considerations: match bond maturities and risk to your goals, weigh the trade-off between yield and credit quality, and understand tax implications (e.g., tax-exempt municipal interest).

Bottom line

Bonds are a core fixed-income tool for yield, income and portfolio diversification. Understanding coupon structure, credit risk, maturity and interest-rate sensitivity (duration) will help you choose bonds or bond funds that fit your investment objectives and risk tolerance.