What Is a Bond?

A bond is a loan. When you buy a bond, you lend money to a government, a city or a company. In return, the borrower promises to pay you interest at set intervals and to repay the original amount on a set date. Bonds are often called fixed income because, unlike a stock's dividend, the payments are agreed in advance.

The parts of a bond#

Most bonds pay their coupon twice a year, so a 5% bond with $1,000 face value pays $25 every six months. Bond prices are usually quoted as a percentage of face value: a quote of 96 means $960 for a $1,000 bond.

Who issues bonds#

• Governments borrow to fund spending. US Treasury bills, notes and bonds are considered among the safest in the world. See Treasury Bills, Notes and Bonds.
• Cities and states issue municipal bonds, which in the United States often pay interest free of federal tax. See Municipal Bonds.
• Companies issue corporate bonds to fund growth or refinance debt. They pay more than government bonds because the risk of not being repaid is higher. See Corporate Bonds.

Why bond prices move#

A bond's coupon is fixed, but its price changes every day. The main reason is interest rates.

This inverse relationship is the most important idea in bonds: when rates go up, bond prices go down, and when rates go down, bond prices go up. Longer maturity bonds move more for the same change in rates, which is measured by Duration.

The second reason is credit. If investors start to doubt that a company can repay, its bond prices fall and their yields rise to compensate for the extra risk. Rating agencies grade issuers to help investors judge this. See Credit Ratings.

Yield: the number that matters#

The yield tells you what you actually earn. If you buy that 5% coupon, $1,000 face value bond for $960, you receive $50 a year plus a $40 gain when it is repaid at $1,000. Your total return per year, called the Yield to Maturity, is higher than 5%. If you paid $1,040, your yield would be lower than 5%. Traders and investors compare bonds by yield, not by coupon.

Risks of bonds#

• Interest rate risk. Rising rates lower the value of existing bonds, especially long ones.
• Credit risk. The issuer may pay late or not at all, called a default.
• Inflation risk. Fixed payments buy less if prices rise faster than expected.
• Liquidity risk. Some bonds trade rarely, and selling before maturity can mean accepting a poor price.
• Call risk. Some bonds let the issuer repay early, usually when rates have fallen, which ends your higher coupon.

If you hold a high quality bond to maturity, price swings along the way do not change what you receive, as long as the issuer pays. If you sell early, they do.

Why bonds matter to stock and crypto traders#

Even if you never buy a bond, bond yields affect everything else. Government bond yields are the benchmark "risk free" return that every other investment is compared with. When yields rise sharply, stocks, especially fast growing companies, often fall, and so do speculative assets. Many traders watch the 10 year Treasury yield every day. See Interest Rates and Yield Curves.

How to own bonds#

You can buy individual bonds through many brokers, buy Treasuries directly from the government in the United States, or buy bond funds and ETFs that hold many bonds at once. Funds are simpler and diversified but have no maturity date, so their prices keep moving with rates. See What Is an ETF? and Bond Trading.

Frequently asked questions#

Are bonds safer than stocks?#

High quality government bonds are generally less volatile than stocks, but bonds still carry interest rate, inflation and credit risk. Low rated corporate bonds can be very risky.

Can you lose money on a bond?#

Yes. If you sell after rates have risen, the price may be lower than you paid, and if the issuer defaults you may lose some or all of your money.

What is the difference between coupon and yield?#

The coupon is the fixed interest rate on face value. The yield is the return based on the price you actually pay, so it changes as the bond's price changes.

Sources#

• U.S. Securities and Exchange Commission, Bonds
• TreasuryDirect, Treasury marketable securities