Bond

A bond is a tradeable IOU. When you buy a bond, you are lending money to a government or corporation and getting a promise in return: they will pay you interest (called a coupon) at regular intervals and repay the full amount (the face value or principal) on a set date (the maturity date). Bonds are the senior alternative to stocks—more stable, lower-return, but paid before shareholders if anything goes wrong.

The simplest financial instrument

In concept, a bond is simpler than a stock. You lend $1,000 to a borrower. They promise to pay you $50 per year (the coupon, 5%) for 10 years, then return your $1,000 on the maturity date. You know exactly what you will receive, when you will receive it—assuming they don’t default.

Bonds are issued by governments (federal, state, local) and corporations. A US Treasury bond is backed by the full faith and credit of the US government, the safest borrower in the world. A corporate bond is backed only by the issuer’s ability and willingness to repay—hence it is riskier and pays a higher coupon.

The coupon is fixed at issuance. If a bond is issued with a 5% coupon, it will pay 5% no matter what happens to interest rates, inflation, or the economy. That is both a virtue and a vice: it is predictable, but if rates rise and new bonds pay 6%, your 5% bond is less attractive.

How bond prices move

Here is where bonds get interesting and slightly counterintuitive. The bond itself (the contract) is fixed. But bonds trade in the secondary market, and their prices change constantly.

Imagine you bought a $1,000 bond paying 5% ($50 per year) with 10 years to maturity. The next day, interest rates rise and new bonds issued at the same credit quality now pay 6% ($60 per year). No one wants to pay $1,000 for a bond that pays 5% when they can buy a new bond that pays 6%. So the price of your bond falls—maybe to $920—so that its yield (the effective return to a new buyer) is 6%.

Conversely, if rates fall and new bonds pay 4%, your 5% bond becomes valuable. Its price rises to maybe $1,080 so that the yield to a new buyer is 4%.

Bond prices and interest rates move inversely. This is one of the most important relationships in finance. When the Federal Reserve raises interest rates, existing bond prices fall. When it cuts rates, they rise.

The longer the maturity, the more the price moves. A 30-year bond is far more sensitive to rate changes than a 2-year bond. This sensitivity is measured by duration.

Credit risk and default

Not all bonds are equally safe. A US Treasury bond is nearly risk-free because the US government can print money and raise taxes. A bond issued by a shaky corporation is risky; if the company fails, you may lose some or all of your money.

Credit rating agencies (Moody’s, Standard & Poor’s, Fitch) assign ratings to bonds to indicate their safety. AAA is the safest (virtually no default risk). AA, A, and BBB are considered investment-grade—safe enough for conservative investors. BB, B, CCC, and below are called high-yield or junk bonds—speculative, riskier, but they pay higher coupons to compensate.

The difference in yield between a safe bond and a risky bond is called the credit spread. In calm markets, the spread is tight (maybe 1–2%). In panics, it widens dramatically (5–10% or more) as investors demand higher compensation for risk.

Default is rare in investment-grade bonds but real in high-yield bonds. Historically, roughly 5% of BB-rated bonds default within five years. Most investors assume they will get most of their money back even in default, but recovery is uncertain.

The role of bonds in a portfolio

Bonds are the dampener in a diversified portfolio. In a bear market, when stocks fall 30%, bonds typically fall only a few percent (or rise, if rates fall in response to the crisis). This is why asset allocation places 40% or more of conservative portfolios in bonds.

The trade-off is clear: bonds offer lower returns but higher stability. Historically, stocks have returned about 9–10% per year (nominal, before inflation); bonds have returned about 5%. Over decades, that 4–5% gap compounds into a vast difference in final wealth. But the ride is smoother.

Bonds are also a source of income. A portfolio of bonds paying 5% can yield 5% per year without selling a single bond—attractive for retirees or those living off their portfolio.

When bonds are risky

Despite their reputation for safety, bonds can become dangerous in certain environments.

Inflation. If inflation rises faster than a bond’s coupon, you lose purchasing power. A bond paying 5% in a 6% inflation environment is paying negative real returns. This happened spectacularly in the 1970s when bond investors lost money in real (after-inflation) terms despite getting paid nominal interest.

Rising rates. If you buy a bond and rates immediately rise, the value of your bond falls sharply. If you hold to maturity, you still get your coupon and face value; but if you need to sell before maturity, you lose. This is duration risk.

Default. A company can always fail, even if unexpected. Holding a concentrated position in corporate bonds from one issuer is risky.

Opportunity cost. If rates are very low and you lock money into bonds paying 2%, and rates later rise to 5%, you have lost the opportunity to earn the higher rate. This is why many investors held cash in the early 2020s waiting for rates to rise.

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