How Bonds Work

A bond is a loan. When you buy a bond, you lend money to an issuer, such as a government or company, which promises to pay interest (coupons) at set intervals and repay the face value (principal) on a set date (maturity). Bonds are the backbone of global finance: the bond market is larger than the stock market by many measures, and bond yields set the cost of borrowing for governments, companies and homeowners. The short introduction is in What Is a Bond?; this lesson explains how bonds are priced and why their prices move.

The parts of a bond#

Price and yield move in opposite directions#

A bond's coupons are fixed. If market interest rates rise, new bonds pay more, so existing bonds with lower coupons must fall in price to offer a competitive yield. If rates fall, existing bonds become more valuable.

Bond pricing#

A bond's price is the present value of its future cash flows, discounted at the market yield:

price = Σ coupon / (1 + y)^t + face value / (1 + y)^n

where y is the yield per period and n is the number of periods. See Time Value of Money and try the Bond Price, Duration and DV01 Calculator.

Premium, par and discount#

Zero coupon bonds pay no coupons and are always issued at a discount, paying face value at maturity.

Clean and dirty prices#

Bonds accrue interest between coupon dates. Quoted prices are usually "clean" (excluding accrued interest); the amount actually paid is the "dirty" or full price, clean price plus accrued interest.

Main types of bonds#

Bond risks#

• Interest rate risk: prices fall when yields rise. Longer bonds are more sensitive. See Duration.
• Credit risk: the issuer may default. See Credit Ratings and Default Probability and Recovery Rate.
• Inflation risk: rising inflation erodes fixed coupons. See Inflation.
• Liquidity risk: some bonds trade rarely and at wide spreads.
• Call risk: issuers may repay early when rates fall.
• Reinvestment risk: coupons may be reinvested at lower rates.

In 2022, as inflation surged and central banks raised rates quickly, broad US bond indices suffered their worst year in decades, with losses of around 13%, a reminder that bonds are not risk free.

How bonds trade#

Most bonds trade over the counter through dealers rather than on exchanges. US Treasuries are among the most liquid securities in the world; many corporate and municipal bonds trade infrequently. Individuals often access bonds through funds and ETFs. See OTC Markets and Bond Trading.

Frequently asked questions#

How do bonds work?#

A bond is a loan to an issuer that pays periodic interest and repays the face value at maturity. Its price changes as market interest rates and credit risk change.

Why do bond prices fall when interest rates rise?#

Because existing bonds pay fixed coupons; when new bonds offer higher yields, older bonds must fall in price to offer a competitive return.

Are bonds safe?#

High quality government bonds have low default risk but can lose value when rates rise. Lower rated bonds carry significant credit risk.

Next, learn about the most important bond market in Treasury Bills, Notes and Bonds.