What Is a Bond?
A bond is a loan to a government or company that pays interest and returns the amount borrowed on a set date. How bonds work, why their prices move, and the risks.
In one sentence
Bond. A loan you make to a government or company. It usually pays you interest and repays the amount borrowed on a set date.
How it works
When you buy a bond, you lend money to whoever issued it, such as the US Treasury, a city, or a company. In return it usually pays a fixed rate of interest, the Coupon. The interest a bond pays, usually as a fixed yearly rate on its face value, paid in installments. Glossary, and repays the face value when the bond matures.
| Face value | $1,000 |
|---|---|
| Coupon | 5% a year |
| Interest each year | $50 |
| Repaid at maturity | $1,000 |
| Total received over 10 years | $1,500 |
Why bond prices move
Bonds keep trading after they're issued, and their prices change. If market interest rates rise to 6%, a new bond pays $60 a year, so nobody will pay the full $1,000 for one paying $50: its price falls until its yield matches what's available. When rates fall, existing bonds rise in price. Why Bond Prices and Yields Move in Opposite Directions works through it step by step.
The main risks
- Interest rates. Rising rates push prices down, and longer bonds fall more. Duration. A measure of how sensitive a bond's price is to interest rate changes. A duration of 6 means a price change of roughly 6% for each 1-point move in rates. More on this term measures how much.
- Credit. The issuer might not pay. Credit rating. A rating agency's assessment of a borrower's ability to repay, expressed as a letter grade such as AAA or BB. More on this term grade that risk.
- Inflation. Fixed payments buy less when prices rise.
Learn it properly
- What Is Investing?Part 1: Foundations · Free
- What a Bond IsPart 2: What You Can Own · Free