Bonds explained for beginners: coupons, yields, interest-rate risk and bond funds
TUREFF• •0
Bonds are the other half of many investment portfolios, but they are often explained in jargon. The basic idea is simple: a bond is a loan, and you are the lender. This guide explains how bonds work and what can go wrong. It is general education, not financial advice.
What a bond is
When a government or company issues a bond, it borrows money from investors. The bond states:
- the face value (or par value), the amount repaid at the end
- the coupon, the interest paid, usually as a fixed percentage of face value, often once or twice a year
- the maturity date, when the face value is repaid
If you buy a bond at issue and hold it to maturity, and the issuer does not default, you receive every coupon and your money back. That predictability is the main appeal.
Price and yield move in opposite directions
Most bonds can be bought and sold before maturity, and their market price changes. Suppose you hold a bond paying 3% a year and new bonds now pay 5%. Nobody will pay full price for yours, so its price falls until its return matches the new bonds. If rates fall, older bonds with higher coupons become more valuable and their prices rise.
- Coupon rate: fixed when the bond is issued.
- Current yield: the annual coupon divided by today's price.
- Yield to maturity: the total annual return if you buy now and hold to the end, counting coupons and the gain or loss back to face value. It is the figure most often quoted.
Interest-rate risk
Because prices fall when rates rise, bonds can lose value. The longer the time to maturity, the bigger the effect. Duration is the measure used for this sensitivity: roughly, a bond or fund with a duration of 7 would lose about 7% of its value if rates rose by one percentage point, and gain about that much if they fell. Short-term bonds move less; long-term bonds move more. If you hold an individual bond to maturity, interim price swings do not change what you get back, but they matter if you need to sell early.
Credit risk
The issuer might fail to pay. Credit ratings from agencies such as S&P, Moody's and Fitch estimate that risk. Bonds rated in the top tiers are called investment grade; those below are high yield, or "junk", bonds. Lower-rated borrowers must pay higher coupons to attract lenders, so a high yield is compensation for risk, not free money.
Government and corporate bonds
- Government bonds issued by financially strong countries in their own currency are generally treated as the lowest credit risk in that market. Examples are US Treasuries, UK gilts and Korean treasury bonds. Some governments also issue inflation-linked bonds whose payments rise with prices.
- Municipal or local government bonds fund regional projects; in some countries their interest has tax advantages.
- Corporate bonds pay more than government bonds of similar maturity because companies are more likely to default. The gap, called the spread, widens when markets are worried.
Inflation is a separate risk for all of them: a fixed coupon buys less as prices rise.
Bond funds and ETFs
Most individual investors hold bonds through funds rather than one by one. A fund owns many bonds, spreading credit risk and making it easy to invest small amounts. The trade-off is that a fund never matures: it keeps replacing bonds, so its price moves with rates indefinitely. When comparing funds, look at:
- the type of bonds (government, corporate, high yield, international)
- average duration, to judge rate sensitivity
- average credit quality
- annual fees
- currency: overseas bonds add exchange-rate risk unless the fund hedges it
Why people hold bonds
Bonds provide income, have often been less volatile than shares, and can cushion a portfolio when stocks fall, though not always: in some years bonds and shares have fallen together. Many investors shift towards bonds as they approach a goal such as retirement.
Tax treatment of bond interest and fund distributions differs by country and account type, so check the rules where you live, and consider a qualified adviser for your own situation.
What part of bonds still puzzles you, or how do you use them in your own portfolio? Ask or share in the comments.