What a Bond Is

Why this matters

Bonds are the other half of many investors' portfolios, and the main ingredient in the conservative end of a target-date fund. They behave differently from stocks, which is exactly why investors hold both. Understanding the basic deal a bond offers makes the rest of this module, and much of Part 5, easier to follow.

A loan, not a slice

When you buy a stock, you become a part-owner of a company. When you buy a bond, you become a lender. The issuer, whether a government, a city, or a company, borrows your money and promises to pay it back with interest.¹

That changes what you can expect. As a lender, you don't share in the borrower's growth: if the company doubles its profits, you still get the same interest. But you're paid before the owners. As What a Stock Is explained, if a company fails, its lenders and bondholders are paid ahead of its shareholders.

The terms every bond has

Every bond comes with a few basic terms:¹

• Face value, also called par value or principal: the amount the issuer promises to repay. It's often $1,000 per bond.
• Coupon: the interest rate the bond pays on its face value. Many bonds pay it in two installments a year.
• Maturity: the date the bond ends and the issuer repays the face value.

Ana buys a newly issued 10-year bond from a fictional company, STU Corp. Face value: $1,000. Coupon: 4% a year, paid in two installments.

Each interest payment (every six months)	$20
Interest per year	$40
Total interest over 10 years	$400
Repaid at maturity	$1,000
Total received, if STU Corp pays everything	$1,400

Those amounts are fixed when the bond is issued. That predictability is the main appeal of bonds, and the condition "if STU Corp pays everything" is the main risk.

Not every bond works exactly this way. Some pay interest that changes with market rates, and a zero-coupon bond pays no interest along the way: you buy it for less than its face value and receive the full face value at maturity.

You don't have to hold to maturity

Many bonds can be bought and sold before they mature, in the bond market. The price you get then depends on conditions at the time, especially interest rates, and can be more or less than you paid.² The next lesson explains exactly why.

The main risks

• Credit risk. The borrower might not pay interest or principal in full and on time. Missing a required payment is called a default.
• Interest rate risk. When market interest rates rise, the prices of existing fixed-rate bonds fall. Longer-term bonds are more affected.²
• Inflation risk. Fixed payments buy less as prices rise, as Inflation and Purchasing Power showed.

Key takeaways

• A bond is a loan to a government or company, which pays interest and repays the face value at maturity.
• Face value, coupon, and maturity are the basic terms of every bond.
• Bondholders are paid before shareholders, but don't share in a company's growth.
• The main risks are default, rising interest rates, and inflation.

Check your understanding

A bond has a face value of $1,000, a 5% coupon paid twice a year, and five years to maturity. How much does each interest payment come to?

1. $50
2. $25
3. $250

A company's profits double over the life of a bond you hold. What happens to your interest payments?

1. They double too, since bondholders share in the company's profits.
2. They rise by the inflation rate, since higher profits usually come with higher prices.
3. They stay the same. A fixed-rate bond pays what it promised, no more.

What's next

The most surprising thing about bonds for many beginners is that their prices move when interest rates change. The next lesson, Why Bond Prices and Yields Move in Opposite Directions, explains why with simple numbers.