A bond is a loan that an investor makes to a government, a company or another issuer. In return, the issuer promises regular interest payments, called coupons, and repayment of the face value on a set date, called maturity. A bond is a contract for future cash payments. It is not a share of ownership in the issuer, so a bondholder does not vote at meetings or share in profits beyond the agreed payments.
This guide explains how a bond's payments work, why its price moves against interest rates, where its return comes from and what the main risks are. The examples use invented figures and assume the issuer pays in full. Real bonds have terms that vary, so read the prospectus or the issue terms before you buy.
What is a bond?
A bond has a few key features. The face value, sometimes called par, is the amount repaid at maturity, often set at 1,000 in the currency of the issue. The coupon rate is the yearly interest as a percentage of face value. The maturity is the date of repayment, and the issuer is the borrower.
Together these define the cash flows the investor expects to receive.
For example, a bond with a face value of 1,000 and a 5 percent annual coupon pays 50 a year until maturity, and then repays 1,000. The payments are fixed in money terms, so the investor knows the amounts in advance, provided the issuer does not default. Bonds can be issued by governments or by companies, and the issuer's financial strength matters a great deal to whether the promised payments arrive.
Credit ratings are one way to judge an issuer. A rating is an opinion from an agency about the likelihood of default, not a guarantee. A higher-rated bond usually pays less than a lower-rated one, because investors accept a lower return for a lower chance of loss. Compare bonds of similar quality and maturity when you judge whether a yield is fair.
How do bond prices move?
Bond prices move in the opposite direction to interest rates. When new bonds pay higher rates, existing bonds with lower coupons become less attractive, so their prices fall. When rates fall, existing bonds with higher coupons become more valuable. The longer the time to maturity, the stronger this effect, because the investor waits longer for the fixed payments to arrive.
The table below uses illustrative figures for a 1,000 bond with a 5 percent coupon and ten years to maturity. Coupons are assumed to be paid once a year. The prices are rounded.
| Market rate for similar bonds | Price of the bond | Change from face value |
|---|---|---|
| 5% | 1,000 | 0% |
| 6% | 926 | −7.4% |
| 4% | 1,081 | +8.1% |
When the market rate rises to 6 percent, buyers can get more interest from new bonds, so the old bond must be sold at a discount to match its yield. When the rate falls to 4 percent, the old bond pays more than new ones, so it sells at a premium. The price moves because the fixed payments are being valued at a different rate, not because the issuer has changed.
Where does a bond's return come from?
A bond's return has two parts: the coupon income and any gain or loss if the bond is sold before maturity. If you hold to maturity and the issuer pays in full, the return is the coupon plus the pull back to face value.
A bond bought below face value adds a gain at maturity, and a bond bought above face value takes a loss as it approaches repayment.
The yield is the usual way to compare bonds. The yield to maturity is the rate that equates the bond's price with the present value of its remaining payments. It allows a buyer to compare a bond bought at a discount with one bought at a premium, and with other bonds of similar quality and maturity. A higher yield usually means more risk, more time, or a lower price.
Inflation affects the real value of the coupons. A bond paying 5 percent while prices rise 9 percent delivers a negative real return in that year, which is the same logic as for cash. The inflation guide explains how to compare any fixed payment with the rise in prices.
What are the main risks?
Bonds carry several risks. Default risk is the chance that the issuer cannot pay. Interest rate risk is the effect of rate changes on the price. Inflation risk is the loss of real value in the payments. Liquidity risk is the chance that a bond is hard to sell at a fair price when you need to.
Each risk depends on the features of the bond, and none is removed simply by holding bonds rather than shares.
Default risk usually rises with the yield. A bond that pays much more than similar bonds may be paying for a real chance of loss, so check the issuer's finances and ratings before you treat a high yield as attractive. Liquidity deserves attention too. Many bonds trade thinly, so the quoted price may not be the price you would receive, and the gap between buying and selling prices can be large. Do not assume that a bond can always be sold at a fair price at the moment you want to sell.
How do you compare two bonds?
Compare bonds with similar credit quality, maturity and payment terms first. Then compare their yields to maturity, and check the price, the coupon and any features that change the cash flows. A bond with a higher yield is not automatically the better buy, because the extra return may be payment for more risk.
Check the time to maturity, since a longer bond usually carries more price risk for a given change in rates. Check the payment frequency and the currency, because both change the cash you receive and the cost of converting it. Check for call features, which let the issuer repay early and may cut your return if rates have fallen.
Common mistakes
Assuming bonds are always safe. A government bond from a stable issuer is different from a high-yield corporate bond. The risk depends on the issuer and the terms.
Ignoring the price effect when rates change. A bond can lose value before maturity, even if the issuer pays every coupon in full.
Comparing yields without checking quality and maturity. A higher yield on a longer or weaker bond may simply reflect higher risk.
Checklist
- Identify the issuer, the face value, the coupon rate and the maturity date.
- Check the issuer's credit rating and read the most recent financial information.
- Compare the yield with bonds of similar quality and maturity.
- Compare the yield with current inflation, after costs and taxes.
- Check how thinly the bond trades and what the buying and selling prices are.
- Think about what happens to the price if market rates rise before you sell.
- Read the issue terms for any call features or other conditions that change the cash flows.
Key takeaways
A bond is a contract to pay interest and repay face value at maturity, not a share of ownership. Its price moves against interest rates, and the effect is larger for longer maturities. Returns come from coupons and any gain or loss on sale, and the yield is the standard way to compare bonds. The main risks are default, interest rates, inflation and liquidity, and each depends on the particular bond.
This guide is for general information, not financial advice. See the disclaimer.