Stocks get the headlines, but bonds make up a huge part of the financial world. Here is how they work.
A loan with paperwork
When you buy a bond, you are lending money to a government or a company. In return, they promise to pay you interest, called the coupon, on a schedule, and to give your money back on a set date, called maturity. A $1,000 bond with a 4% coupon pays $40 a year until it matures.
Who issues bonds
- Governments issue treasuries or government bonds, usually seen as the safest.
- Companies issue corporate bonds, which pay more because they carry more risk.
Why prices move with interest rates
This is the part that trips people up. If new bonds start paying 5%, nobody wants your old 4% bond at full price, so its market price drops. When rates fall, older bonds with higher coupons become more valuable. Prices and rates move in opposite directions.
The risks
- Interest rate risk: longer bonds move more when rates change.
- Credit risk: the borrower might not pay you back.
- Inflation risk: if inflation is higher than your coupon, you lose buying power.
Where bonds fit
Investors often hold bonds to steady a portfolio, since they tend to swing less than stocks. You can buy individual bonds or use a bond ETF or fund. The right mix depends on your age, goals and how much ups and downs bother you.
Bond prices and rates: a worked example
Say you buy a new 10-year bond for $1,000 that pays a 4% coupon, or $40 a year. A year later, new 10-year bonds pay 5%. Nobody will pay full price for your 4% bond when they can get 5% elsewhere, so its market price drops until its yield matches the market. For a bond with about 10 years left, that is roughly $923. If rates had fallen to 3% instead, your bond would be worth more than $1,000. Hold to maturity and you still get the full $1,000 back, as long as the issuer does not default.
Coupon vs yield
The coupon is the fixed interest rate printed on the bond. The yield is the return you actually earn based on the price you pay today. Buy below face value and your yield is higher than the coupon; buy above face value and it is lower. When news says “bond yields rose,” it means bond prices fell.
Common types of bonds
- Government bonds: US Treasuries, Canadian Government bonds and UK gilts. The lowest credit risk in each country.
- Inflation-protected bonds: TIPS and I bonds in the US, index-linked gilts in the UK. Payments rise with inflation.
- Corporate bonds: issued by companies. Higher yields, more default risk, especially for “high yield” or junk bonds.
- Municipal bonds: issued by US states and cities. Interest is often free of federal income tax.
Bond funds vs individual bonds
Most beginners own bonds through a bond ETF or mutual fund. A fund gives instant diversification across hundreds of bonds and trades easily, but it never “matures,” so its price keeps moving with rates. An individual bond returns your face value at maturity, which helps if you need a set amount on a set date. Learn more in what is an ETF and why the Fed raises interest rates.
- Live prices and sentiment on every ticker page
- Weekly email with your watchlist movers
- Price alerts on the stocks and coins you follow
Frequently asked questions
How do bonds work for beginners?
A bond is a loan you make to a government or company. You get regular interest payments, called coupons, and your original amount back on the maturity date.
Why do bond prices fall when interest rates rise?
Existing bonds pay a fixed rate. When new bonds pay more, older bonds become less attractive, so their price drops until their yield matches what new bonds offer.
Are bonds safer than stocks?
High-quality government bonds usually move much less than stocks and are less likely to lose money over short periods. They can still fall when rates rise, and over long periods they have typically earned less than stocks.
Related reading
This is general education, not financial advice.
Leave a Reply