What Are Bonds? Understanding Fixed Income Investing

A bond is the simplest deal in finance: you lend money to a borrower — a government, a corporation, some other organization — and in exchange they promise two things. They pay you interest (a fixed coupon) at regular intervals, and they repay your principal when the bond matures. That’s why the asset class is called fixed income: the payment stream is spelled out in advance.

Here’s the catch, and it’s the thread this whole article hangs on: even though the payments are fixed, the bond’s price is not. It moves every day, driven by interest rates, and it moves in a direction beginners consistently get backwards. Understanding that seesaw — and how hard it swings — is most of what there is to understand about bonds.

First, the vocabulary. The face (par) value is what gets repaid at maturity, usually $1,000 for corporate bonds. The **coupon rate** is the annual interest paid on that face value — a 5% coupon on $1,000 face pays $50 a year. The maturity date is when the principal comes back; bonds run from 1 year to 30 years and beyond. And the yield to maturity (YTM) is the total return you earn if you hold to maturity and every promised payment arrives.

The seesaw: prices and yields move opposite

A bond’s price is just its future payments, discounted back to today at the yield $y$:

where $n$ is years to maturity. The yield sits in every denominator — so when yields rise, every discounted payment shrinks, and the price falls. Bond prices and yields move in opposite directions. Always.

Work one example and it stops being abstract. Take a $1,000 face bond with a 5% coupon and 3 years to maturity. If its YTM is 5%, the discounting exactly offsets the coupons and it trades at par: $1,000. Now suppose market yields rise to 6% — your bond still pays only $50 a year while new bonds pay $60, so nobody will pay full price for yours. Its price falls to about $973. If instead yields drop to 4%, your 5% coupon becomes the attractive one, and the price rises to about $1,028.

Rising yields, falling prices; falling yields, rising prices. Everything else in this article is a variation on that seesaw.

Who borrows, and what their promises are worth

The seesaw applies to every bond, but not every borrower’s promise is equally good — and that difference is priced.

Governments sit at the safe end. Their bonds are generally considered the lowest-risk (not zero — Greece restructured in 2012, Russia defaulted in 1998). US Treasuries come in three maturities: Bills (a year or less), Notes (2-10 years), Bonds (10-30 years). The UK’s are called Gilts, Germany’s Bunds. One special variant is worth knowing: TIPS (Treasury Inflation-Protected Securities), the marketable US government bonds whose principal adjusts with CPI inflation — if inflation rises, so does the amount you’re owed.

Corporations pay more than governments precisely because they might not pay at all. Corporate bonds split into investment grade (rated BBB- and above: lower risk, lower yield) and high yield — bluntly, junk (BB+ and below: higher risk, higher yield). In between, US cities and local governments issue municipal bonds, often tax-exempt in the US.

Who decides what counts as investment grade? Rating agencies — S&P, Moody’s, Fitch — grade each issuer’s ability and willingness to repay:

The scale maps directly onto the price: higher rating, lower yield; lower rating, higher yield to compensate for the risk. Credit risk shifts where a bond sits on the yield spectrum — but how violently its price reacts to rate moves is a separate question, and it has its own number.

Duration: how hard the seesaw swings

Duration measures how much a bond’s price changes when interest rates move. A bond with a duration of 8 falls roughly 8% if rates rise one percentage point. It’s the sensitivity dial on the seesaw.

Three things turn the dial up: longer maturity, lower coupon, lower yield. The intuition is the same for all three — the further away your cash is, the more a change in the discount rate matters. Compare three bonds that differ only in maturity:

Same coupon, same yield — but the 30-year bond is about eight times as sensitive to rates as the 2-year. “Safe” long-term government bonds can lose double-digit percentages in a year when rates climb. The default doesn’t have to happen; the discounting does the damage on its own.

The yield curve: the market’s forecast, drawn as a line

Plot yields against maturities for bonds of the same credit quality and you get the yield curve — and it’s one of the most watched charts in finance, because its shape encodes what the market expects.

A normal curve slopes upward: long-term yields above short-term, consistent with an economy expected to grow normally. An inverted curve slopes downward — short rates above long rates — and has often preceded recessions, which is why an inversion makes headlines. A flat curve, with similar yields across maturities, usually marks a transition between the two.

Why any of this matters if you never buy a bond

Even if you never own a single bond, this market reaches you three ways.

First, bond yields are everyone’s discount rate. Government bond yields are the foundation of the “risk-free rate” used to discount all future cash flows — including the stock valuations covered elsewhere in this section. When yields move, every asset gets repriced.

Second, government bonds are where money hides. In a crisis, investors flee risk: stock prices fall while government bond prices rise (and their yields fall) — the flight to safety. That negative correlation in bad times is exactly why portfolios pair stocks with bonds.

Third, the bond market sets your mortgage. The 30-year US mortgage rate closely tracks the 10-year Treasury yield; when bond yields rise, mortgage rates follow.

Add it up and the bond market — larger than the stock market globally — is less a sleepy corner of finance than its plumbing: the place where the price of time and the price of safety get set, and everything else drains through it. For the full machinery, Fabozzi is the standard reference, and Bodie, Kane & Marcus cover pricing and duration formally.

References

• Fabozzi, Fixed Income Securities. Wiley, 2011. ISBN: 978-0-470-39970-1.
• Bodie, Kane, Marcus, Investments, Ch. 10-11. McGraw-Hill, 2020. ISBN: 978-1-26-057101-6.