Bonds: How do they work?

A bond is a fixed-income investment where you lend money to a government or company at a set interest rate for a specific time period. The borrower pays you back with interest plus your original money when the bond ends.

Bonds are used by companies, states, and governments to raise money for projects and daily operations. When you own bonds, you become a creditor of whoever issued the bond. Bond details include the end date when your original money gets paid back and the terms for interest payments from the borrower.

Fundamentals

Here's the simple idea: you lend money today and get regular payments plus your money back later.

When you buy a bond, you get a document that shows three key things. The face value is how much you'll get back. The interest rate is how much they pay you each year. The maturity date is when they pay you back your original money.

Most bonds pay interest twice a year. So if you buy a $1,000 bond with 5% interest, you get $25 every six months.

Important Bond Words:

• Issue Price: The price you pay for the bond
• Face Value: What you get back when the bond ends
• Interest Rate: How much they pay you each year
• Maturity Date: When you get your original money back

Here's something important: when interest rates go up, bond prices go down. When rates go down, bond prices go up. This happens because new bonds with higher rates make old bonds less desirable and therefore less valuable.

Bond Pricing

The current price of a bond depends on how its interest rate compares to today's market rates. If your bond pays 5% interest but new bonds pay 6%, your bond becomes less valuable. Someone would rather buy the new 6% bond than your 5% bond.

This creates the market price of your bond. When your bond's rate is lower than current rates, it trades below par (less than face value). When your bond's rate is higher than current rates, it trades above par (more than face value).

The closer your bond gets to its maturity date, the closer its price moves toward face value. This happens because you'll get the full face value back regardless of what you paid for it.

Example

Let's say Apple Inc. issues a bond with a face value of $1,000 with an annual 5% interest rate paid annually that matures in 10 years. The current market interest rate is 6%.

• Face Value: $1,000
• Interest Rate: 5%
• Market Interest Rate: 6%
• Interest Payment: $50 every year
• Maturity Date: 10 years

The formula for the market price of a bond is:

where:

So the market price of your bond is:

This means that the bond is trading at a discount because the interest rate is lower than the market interest rate.

Federal Funds Rate Impact on Bond Prices

The Federal Funds Rate directly influences bond prices across the market. When the Fed raises rates, existing bonds with lower rates become less attractive, causing their prices to fall.

The chart below tracks two key rates over more than 60 years. The blue line shows the Federal Funds Rate, which the Federal Reserve sets as a policy tool. The red line shows the 10-Year Treasury Yield, which represents what investors demand to hold government bonds for a decade.

What the data shows:

The chart reveals several major rate cycles. In the early 1980s, both rates peaked dramatically as the Federal Reserve fought inflation. The Fed Funds Rate reached 19.08% in January 1981, while the 10-Year Treasury Yield hit 15.84% in September 1981. These extraordinarily high rates made existing bonds with lower yields worth significantly less.

From the early 1980s through 2020, rates generally trended downward. The 2008 financial crisis marked a turning point. The Fed dropped its rate to near 0.16% by December 2008 and kept it historically low through 2015. During this period, bond prices rose because existing bonds with higher yields became more valuable as new bonds offered minimal returns.

The most recent major shift began in 2022. After maintaining near-zero rates during the pandemic, the Fed raised rates aggressively to combat inflation. The Fed Funds Rate jumped from 0.08% in February 2022 to 5.33% by July 2023. This rapid increase caused significant bond price declines, as bonds issued before 2022 with lower yields became less attractive compared to newly issued bonds offering higher rates.

Frequently Asked Questions