Bonds

Overview

Bonds are contracts through which governments, companies, and other organizations borrow from investors. Their promised payments may look predictable, but their market value and ultimate return still depend on interest rates, inflation, credit quality, and the bond's terms.

A bondholder is a lender rather than an owner of the issuer. The promise to pay is a contractual obligation, not a guarantee that the issuer will always have the resources to meet it. This uncertainty is part of a bond's relationship between risk and return.

The cash flows written into a bond

Many bonds are built around three core terms:^[1]

• Face value or par value: the principal amount used to calculate payments and normally repaid at maturity.
• Coupon rate: the stated annual interest rate applied to face value.
• Maturity date: the date on which the principal is scheduled to be repaid.

For example, a bond with a $1,000 face value and a 4% annual coupon promises $40 of interest per year. If it pays twice a year, each coupon payment is $20. Assuming the issuer does not default and the bond is not called early, the $1,000 principal is repaid at maturity.

Not every bond follows this pattern. Zero-coupon bonds make no periodic coupon payments and are generally issued or traded below the amount repaid at maturity. Floating-rate bonds reset their coupons using a reference rate. Inflation-linked bonds adjust specified payments according to an inflation measure. The legal terms determine the actual cash flows.

Coupon, price, and yield answer different questions

The coupon rate is based on face value and normally does not change for a fixed-rate bond. The market price is what a buyer pays for the bond today and can be above or below face value. Yield expresses return relative to price under a stated calculation and set of assumptions.

If a $1,000-face-value bond pays a $40 annual coupon:

• at a $1,000 market price, its current yield is 4%;
• at an $800 market price, its current yield is 5%;
• at a $1,200 market price, its current yield is about 3.3%.

Current yield divides the annual coupon by the market price. It ignores the gain or loss between today's price and the principal repaid at maturity, the time value of each cash flow, default, and reinvestment. Yield to maturity is broader: it is the discount rate that equates the bond's price with its promised coupons and principal, assuming the bond is held to maturity and payments occur as scheduled. It is still a calculated yield, not a guaranteed return.

Why bond prices move when market yields change

Suppose an existing fixed-rate bond pays 3%, while newly issued bonds with similar maturity and credit risk begin offering 4%. A buyer will generally pay less for the old bond so that its fixed payments provide a competitive yield. If comparable new yields fall to 2%, the old 3% payments become more attractive and its price may rise.

This inverse relationship between yields and fixed-rate bond prices is a central source of interest-rate risk.^[2] The relationship is strongest when other factors, especially credit risk and expected cash flows, remain unchanged.

Longer-maturity and lower-coupon bonds are generally more sensitive to a given change in yield because more of their value comes from payments farther in the future. Duration summarizes price sensitivity to yield changes, but it is an approximation and can change as time, price, yield, and embedded options change.

The issuer's ability to pay matters

Credit risk is the possibility that the issuer will delay or fail to make promised payments. Investors commonly demand a higher yield from issuers seen as less creditworthy. That additional yield is compensation for risk, not proof that the bond will deliver a better realized return.

Credit ratings offer one assessment of default risk, but they are opinions rather than guarantees. They can change after a bond is purchased and do not fully describe interest-rate, inflation, liquidity, or valuation risk.

In insolvency, bondholders usually rank ahead of common shareholders, but priority varies among bonds. Secured debt may have a claim on specified collateral; subordinated debt ranks behind senior debt. Recovery can still be far below face value.

Holding to maturity does not remove every risk

If an issuer makes all payments and the bond is held to maturity, interim market-price changes do not alter the bond's promised principal repayment. That does not make the investment risk-free:

• the issuer may default;
• inflation may reduce the purchasing power of coupons and principal;
• coupon payments may have to be reinvested at lower rates;
• a callable bond may be repaid early, often when reinvestment opportunities are less attractive;
• the investor may need to sell before maturity at a loss;
• currency movements may affect the investor's home-currency return.

The purchase price also matters. An investor who buys a bond above face value can receive less principal at maturity than was paid, even if every contractual payment is made.

Individual bonds and bond funds behave differently

An individual bond has a stated maturity date and contractual cash flows. A bond fund holds a changing portfolio of bonds and normally has no date on which an investor is promised the original purchase amount. Its share price reflects the market value of its holdings, less liabilities.

A fund can provide broader issuer diversification and reinvest cash flows continuously, but it remains exposed to changes in yields, credit spreads, and fund costs. Comparing a bond fund with one individual bond therefore requires more than comparing their distribution rates.

Frequently Asked Questions