Lesson 3.3: Bonds

Lesson Overview

A bond is a loan. When you buy a bond, you are lending money to a government, a municipality, or a company. In return, the borrower promises to pay interest and repay the principal according to a schedule.

Bonds are often called fixed income investments because many bonds pay regular interest. They can play a stabilizing role in portfolios, but they are not risk free. Bond investors face risks such as interest rate changes, inflation, and the chance that a borrower cannot repay.

Learning Objectives

• Define what a bond is and identify its key parts.
• Explain how bond investors earn returns.
• Distinguish coupon rate from yield and yield to maturity.
• Explain why bond prices move opposite interest rates.
• Identify major bond risks, including credit and interest rate risk.
• Understand why maturity and duration affect sensitivity to rate changes.

The Building Blocks of a Bond

Key Terms

• Issuer - the borrower (government or company)
• Face value (par) - the amount repaid at maturity (often $1,000 per bond)
• Coupon - the interest payment amount
• Coupon rate - coupon as a percentage of face value
• Maturity - the date when principal is repaid
• Price - what you pay today in the market

Example

If a bond has a face value of $1,000 and a coupon rate of 5%, it pays $50 per year in interest (often in two $25 payments). At maturity, the issuer repays the $1,000 principal.

How Bond Investors Make Money

Bond returns generally come from:

• Interest payments (coupon income)
• Price changes (bond prices move when yields move)
• Reinvestment (what you earn when you reinvest coupon payments)

Many beginners assume bonds only pay coupons and never change in value. In reality, bond prices can move a lot, especially when interest rates change quickly.

Coupon Rate vs. Yield

The coupon rate is fixed when the bond is issued, but the bond’s yield depends on the price you pay.

Current Yield

A simple yield measure is:

• Current yield = annual coupon ÷ current price

Current yield is useful, but it does not include gains or losses you might realize if you hold the bond to maturity.

Yield to Maturity (YTM)

Yield to maturity is a more complete measure. It is the approximate annual return you would earn if you buy the bond at today’s price, hold it to maturity, and the issuer makes all promised payments.

YTM is still an estimate. It depends on assumptions, including reinvestment rates and no default.

Why Bond Prices Move When Interest Rates Change

Here is the core idea: new bonds are issued at current market interest rates. If market rates rise, new bonds pay higher coupons. That makes older, lower-coupon bonds less attractive unless their prices fall.

The Price Yield Relationship

• When yields go up, existing bond prices go down.
• When yields go down, existing bond prices go up.

Simple Intuition

If you own a bond paying 3% and new bonds now pay 5%, a buyer will not pay full price for your 3% bond. They demand a discount so the total return becomes competitive with the new market rate.

Maturity and Duration: Why Some Bonds Move More Than Others

Bonds with longer maturities tend to be more sensitive to interest rate changes, because more of their value depends on payments far in the future.

Maturity

• Short-term bonds generally have lower interest rate sensitivity.
• Long-term bonds generally have higher interest rate sensitivity.

Duration

Duration is a common measure of how sensitive a bond’s price is to interest rate changes. You can think of it as a “rate sensitivity score.”

The takeaway: when rates change, long duration bonds usually move more than short duration bonds.

Major Risks Bond Investors Face

Credit Risk

Credit risk is the risk the issuer cannot make payments. Credit risk is usually higher for companies than for strong sovereign governments, and it increases when a company has high debt or unstable profits.

Interest Rate Risk

Interest rate risk is the risk that rising market rates will reduce the price of your bond. This risk tends to be higher for longer maturity, longer duration bonds.

Inflation Risk

Inflation reduces the purchasing power of future interest and principal payments. Even if you receive every promised dollar, those dollars may buy less in the future.

Liquidity Risk

Some bonds trade frequently and are easy to sell. Others may be harder to sell quickly without accepting a lower price. Liquidity risk often matters most during market stress.

Reinvestment Risk

If you rely on bond income, you may need to reinvest coupons. If rates fall, you may have to reinvest at lower yields, reducing your future income.

Call Risk

Some bonds are callable, meaning the issuer can repay them early. If rates drop, the issuer may refinance and call the bond. Investors then lose a higher coupon stream and must reinvest at lower rates.

Types of Bonds (Big Picture)

• Government bonds - issued by national governments
• Municipal bonds - issued by cities, states, and local entities
• Corporate bonds - issued by companies
• Investment grade - higher credit quality, lower default risk
• High yield - lower credit quality, higher yields, higher default risk

Higher yield often means higher risk. The reason yields are higher is usually because investors need extra compensation for uncertainty.

Bond Prices, Ratings, and Spreads

Bond markets often compare riskier bonds to safer benchmarks. The difference in yield is called a spread.

• Spread is extra yield demanded for taking additional risk.

Spreads tend to widen when investors feel nervous about the economy and narrow when confidence returns.

Practical Framework: Choosing Bonds for a Goal

1. Define the purpose: stability, income, diversification, or saving for a deadline.
2. Match the timeline: use shorter maturities for near-term needs.
3. Choose credit quality deliberately: higher yield is not free money.
4. Know what risk you are taking: rate risk, credit risk, inflation risk, or all three.

Common Mistakes to Avoid

• Assuming bonds cannot lose value because they pay interest
• Focusing on coupon rate and ignoring yield and price
• Taking long duration risk unknowingly
• Chasing yield without understanding credit risk
• Ignoring inflation when planning long-term purchasing power

Mini Case: Why a Bond Fund Can Fall When Rates Rise

Bond funds own many bonds and update their value daily based on market prices. If interest rates rise, the prices of existing bonds tend to fall, which can temporarily lower the value of a bond fund.

Over time, higher yields can improve future income as the fund reinvests and replaces older bonds, but the short-term price impact can surprise investors who expect bonds to always be stable.

Key Terms

• Bond - a loan made by an investor to an issuer
• Issuer - borrower that sells the bond
• Coupon - interest payment
• Coupon rate - coupon as a percentage of face value
• Maturity - when principal is repaid
• Yield - return based on price and payments
• Yield to maturity - estimated annual return if held to maturity with no default
• Duration - sensitivity of price to interest rate changes
• Credit risk - risk issuer cannot pay
• Spread - extra yield demanded for additional risk

Practice: Check Your Understanding

1. What is the difference between coupon rate and yield?
2. Why do bond prices generally fall when market interest rates rise?
3. Which is usually more rate-sensitive: a short-term bond or a long-term bond?
4. Name two risks bond investors face besides credit risk.
5. What does a widening spread often signal about market confidence?

What’s Next?

In Lesson 3.4: Mutual Funds, we will cover professional management, diversification, fees, and how mutual fund structures work.