Markets
Bonds explained: what you own when you lend
Shares get all the attention, and bonds are where most beginners get quietly confused, usually at the moment somebody says that bond prices fall when interest rates rise. That sentence is not mysterious. It is arithmetic, and it takes about four minutes.
A bond is a loan you made, written down and made tradable. A government or a company needs money, agrees to pay a stated amount of interest on a schedule, and agrees to return the amount borrowed on a stated date. You can hold that agreement until the end, or sell it to somebody else in the meantime.
That is the whole instrument. Every strange thing bonds do follows from the fact that the payments are fixed while the world around them is not.
What a bond is
Four numbers define one, and once you can read those four you can read any bond.
- Face value
- The amount returned at the end, also called par value. Commonly quoted as 1,000 for convenience.
- Coupon
- The interest paid, stated as a percentage of face value. A 4 percent coupon on a 1,000 bond pays 40 a year, usually in two instalments, and that amount never changes.
- Maturity
- The date the face value is returned. A five year bond and a twenty year bond behave very differently, as the section below shows.
- Yield
- The return implied by the price you actually pay. The one number that moves, and the source of most of the confusion.
The critical distinction between the middle two and the last one is this: the coupon is a promise, the yield is a calculation. The borrower promises 40 a year. What that 40 represents as a percentage depends entirely on what you paid for the right to receive it.
The coupon, and what it does not change
Buy a new 1,000 bond with a 4 percent coupon and you receive 40 a year. Buy the same bond later on the secondary market for 800, and you still receive 40 a year, because the coupon is fixed to the face value rather than to your purchase price. Your yield, however, is 40 divided by 800, which is 5 percent.
That single relationship, income divided by price, contains the entire mechanism. Nothing else is needed to understand the next section.
Why prices move opposite to rates
Suppose you hold that 1,000 bond paying 40 a year. Now new bonds of similar quality start being issued with 5 percent coupons, paying 50 a year for the same 1,000.
Nobody will pay you 1,000 for a stream of 40 when the same 1,000 buys a stream of 50 elsewhere. Your bond is not defective and the borrower has not failed. It is simply less attractive at that price, so the price adjusts until the income it provides is competitive.
The same 40 a year, at three different prices
- Priced at 1,000 4.0% yield
- Priced at 800 5.0% yield
- Priced at 1,333 3.0% yield
Division only: 40 divided by the price. This isolates the mechanism by ignoring the return of face value at maturity, which softens the effect on a real dated bond. Illustrative arithmetic, not a quote for any actual security.
So the famous inverse relationship is not a market convention or a piece of received wisdom. It is what has to happen when a fixed payment meets a changed set of alternatives. Rates up, price of existing fixed payments down. Rates down, price up.
Why longer bonds move more
The example above overstates the effect for a real bond, because a real bond also returns its face value on a known date, and that repayment pulls the price back towards 1,000 as the date approaches. The nearer the end, the less a change in rates can move the price.
| Time to maturity | If yields fall to 3% | If yields rise to 5% |
|---|---|---|
| 5 years | about $1,046 | about $957 |
| 20 years | about $1,149 | about $875 |
The word for this sensitivity is duration, and the practical version of it is short: the longer the remaining life of a bond, the more its price moves when rates move. A long dated bond is not a safer version of a share; it is a different instrument with its own kind of volatility.
The three risks worth knowing
Bonds are routinely described as safe, which is too blunt to be useful. There are three distinct risks, and they behave differently.
- Interest rate risk. Everything above. The price of what you hold moves when rates elsewhere move, and it matters if you sell before maturity. Hold to maturity and, if the borrower pays, you receive face value regardless of what happened in between.
- Credit risk. The borrower may not pay. This ranges from negligible to substantial depending on who is borrowing, and it is the reason two bonds with identical coupons can trade at very different prices.
- Inflation risk. The payments are fixed in currency terms, so rising prices erode what they buy. A 4 percent coupon during a period of 5 percent inflation is a real loss dressed as an income, which is exactly the mechanism in how inflation affects your savings.
What bonds are for in a portfolio
Not primarily growth. Over long periods, lending to somebody has generally produced less than owning them, which is unsurprising: the lender takes less risk and gets paid accordingly.
What bonds contribute is different behaviour. They respond to different pressures than shares do, which is the fourth axis of diversification, and they produce a scheduled income rather than a discretionary one. For a portfolio, that usually shows up as smaller swings, which matters less mathematically than behaviourally, as covered in how much risk can you actually live with.
Most beginners meet bonds inside a fund rather than individually, which changes one thing worth knowing. A bond fund has no maturity date, because it continuously buys and sells bonds. The comfort of holding to maturity and receiving face value does not apply to the fund as a whole, so a bond fund can show a loss in a way an individual held bond would not.
Common questions
If I hold to maturity, do price moves matter?
For your own outcome, much less. You receive the coupons and, if the borrower pays, the face value on the date. The price in between matters if you need to sell, and it is what a fund holding bonds reports every day.
Are government bonds risk free?
They are usually the lowest credit risk available in their own currency, which is not the same as risk free. Interest rate risk and inflation risk apply in full, and a long dated government bond can lose value substantially without anybody defaulting on anything.
Why would anyone accept a lower yield?
Because yield is compensation for risk, and lower risk commands a lower payment. A high yield is a fact about the price somebody was willing to accept, which usually means the market sees something worth being compensated for.
Should a beginner hold bonds at all?
That is an allocation decision, and this site does not make them for anybody. What is worth understanding first is what bonds do inside a portfolio, which is described above, and how that interacts with the size of fall you can sit through.
Every figure on this page is illustrative arithmetic, worked at stated rates on an invented bond, and no real security, issuer or fund is referred to. Nothing here is a recommendation to buy, sell or hold bonds of any kind.