What is a bond?
A bond is a loan from an investor to a borrower, usually a government or corporation, that promises regular interest payments and repayment of the principal on a fixed date. When you buy a bond, you become the lender. The borrower, called the issuer, uses your money to fund operations, projects, or refinancing, and in return pays you a fixed interest rate, called the coupon, until the bond matures and the principal, called the face or par value, is returned.
Bonds differ from stocks in one fundamental way: they are a contract, not ownership. A stock gives you a slice of a company with no promised payments; a bond gives you a legal claim to interest and principal, and bondholders are paid before stockholders if the issuer fails. This lesson explains how that contract works; it does not recommend buying bonds or promise any return.
Anatomy of a bond: face value, coupon, maturity
Every bond is defined by three numbers. The face value, usually $1,000 per bond, is the principal repaid at maturity. The coupon rate is the annual interest rate applied to the face value: a 5 percent coupon on a $1,000 bond pays $50 per year, typically split into two $25 semiannual payments. The maturity date is when the final coupon is paid and the $1,000 comes back. Buy a new 10-year bond at par and hold it to maturity, and the deal is exactly what the contract says.
Bonds also trade on a secondary market before maturity, which is where prices start moving. A bond rarely trades at exactly face value after issuance: it trades at a premium (above par) or a discount (below par) depending on interest rates, the issuer's credit health, and time left to maturity. A bond approaching maturity converges toward par regardless, because the remaining payments are nearly certain and nearly due, a pull traders call pull to par.
Two related terms appear constantly. Yield to maturity is the total annualized return if you buy at the current price and hold to maturity, combining coupons and the price gain or loss to par. Current yield is simpler: annual coupon divided by current price. For a bond bought at par, all three numbers, coupon rate, current yield, and yield to maturity, are identical. The moment the price moves off par, they diverge, which leads to the most important relationship in fixed income.
Why bond prices fall when rates rise
Bond prices and interest rates move in opposite directions, always. The logic is mechanical. As an illustration, suppose you hold a $1,000 bond paying a 5 percent coupon, or $50 a year. If new bonds now pay 6 percent, nobody will pay you full price for your 5 percent bond when a 6 percent bond is available. Your bond's price must fall until its yield to maturity matches the market rate. The fixed coupons did not change; the price adjusted so the yield competes.
The reverse holds too: when rates fall, existing bonds with higher coupons become more valuable and their prices rise. This is why bond funds gained strongly during rate-cutting cycles and lost value when central banks raised rates. The sensitivity of a bond's price to rate changes is measured by duration: roughly, a bond with a duration of 7 years loses about 7 percent of its price for each one-percentage-point rise in rates, and gains about 7 percent for each point fall. Longer maturities and lower coupons mean higher duration and bigger swings.
This relationship is also why bonds and stocks often move differently, a point that matters for what moves stock prices. Rising rates pressure both: bond prices fall mechanically, and stock valuations compress as future earnings are discounted at higher rates. Falling rates lift both. The diversification benefit of bonds comes not from immunity to rates but from their contractual cash flows and seniority in distress.
The main types of bonds
Issued by national governments. U.S. Treasuries are the global benchmark for safety: T-bills mature in under a year, notes in 2 to 10 years, bonds in 20 to 30 years. Effectively no default risk, but full exposure to interest-rate and inflation risk.
Issued by states, cities, and local agencies. Interest is often exempt from federal income tax, and sometimes state tax too, which makes their lower headline yields competitive for high earners on an after-tax basis.
Issued by companies to fund operations and expansion. They pay higher yields than Treasuries to compensate for default risk. Investment-grade corporates come from financially strong issuers; high-yield or junk bonds come from weaker ones and pay more.
Inflation-linked bonds such as TIPS adjust principal with inflation. Callable bonds let the issuer repay early, usually when rates fall. Convertible bonds can convert into stock, blending bond income with equity upside.
The yield spread, the extra yield a corporate bond pays over a Treasury of the same maturity, is the market's live price of default risk. Spreads widen when investors fear recession and narrow when confidence returns. Watching spreads is one of the standard ways professionals read the bond market's mood, and it often moves before stock headlines catch up.
Credit ratings and default risk
Credit rating agencies, principally S&P, Moody's, and Fitch, grade issuers on their ability to pay. Ratings run from AAA down through BBB, which is the lowest rung of investment grade, and then into speculative territory: BB, B, CCC, and below, down to D for default. Investment-grade bonds are considered suitable for conservative portfolios; high-yield bonds, nicknamed junk bonds, compensate for real default risk with higher coupons.
Ratings matter because they move prices and determine who can buy. Many pension funds and insurers are restricted to investment-grade bonds, so a downgrade from BBB to BB, called falling to junk or becoming a fallen angel, can trigger forced selling and a sharp price drop. Upgrades work in reverse. Rating agencies are famously slow, though: they often downgrade after the market has already priced in trouble, so professionals treat ratings as one input among many, not a verdict.
If an issuer does default, bondholders have a legal claim and stand ahead of stockholders. Recovery depends on seniority: secured bonds backed by collateral are paid first, then senior unsecured, then subordinated, with stockholders last and often wiped out. This pecking order is the reason bonds are called senior securities and why even distressed bonds can retain significant value while the stock goes to zero.
The risks that remain in the "safe" asset
Bonds are steadier than stocks, not risk-free. Interest-rate risk is the everyday one: prices fall when rates rise, and long-term bonds can swing like stocks. Inflation risk is the quiet one: fixed coupons lose purchasing power when inflation runs hot, which is why inflation-linked bonds exist. Default risk is the dramatic one: the issuer fails to pay, and while rare for highly rated issuers, it is the entire reason corporate bonds yield more than Treasuries.
Two subtler risks deserve mention. Call risk: if your bond is callable and rates fall, the issuer refinances and hands your principal back early, exactly when reinvesting it pays less. Liquidity risk: many corporate and municipal bonds trade infrequently, so selling in a hurry can mean accepting a painful discount. Individual bonds avoid the fund problem of never maturing, but they concentrate default risk in single issuers, which is why diversification across issuers and maturities matters here as much as anywhere.
The practical takeaway: match the bond to the job. Money needed on a known date pairs with a bond maturing near that date, held to maturity, which neutralizes price risk. Money seeking steady income accepts price wiggles along the way. And any yield that looks generous next to Treasuries is the market telling you, in its precise numerical way, that something could go wrong.
Questions about bonds
What is the difference between a bond and a stock?
A bond is a loan: you lend money to the issuer, which promises interest and repayment of principal. A stock is ownership with no promised payments. Bondholders are paid before stockholders if the issuer fails, but stockholders keep the upside if the company thrives.
Why do bond prices fall when interest rates rise?
A bond's coupon payments are fixed, so when new bonds pay higher rates, the older bond must get cheaper for its yield to compete. The price adjusts until the yield to maturity matches what the market demands. Price and yield always move in opposite directions.
Are government bonds risk-free?
U.S. Treasury bonds carry effectively no default risk, but they still carry interest-rate risk and inflation risk. Their market price falls when rates rise, and inflation erodes the purchasing power of their fixed payments.
What happens if a bond issuer defaults?
Bondholders have a legal claim on the issuer's assets and stand ahead of stockholders in bankruptcy. Secured and senior bondholders are paid first, junior bondholders later, and stockholders last, often receiving nothing.
What is a bond fund?
A bond fund pools investor money to buy many bonds at once, giving instant diversification across issuers and maturities. Unlike an individual bond, a fund has no maturity date at which you get a fixed principal back; its price moves daily with the bond market.
Can I lose money investing in bonds?
Yes. Selling before maturity can lock in a price below what you paid, especially after rates rise. Default and inflation can also destroy value. Holding to maturity eliminates price risk but not default or inflation risk.
StockEyes provides informational research organization and transparent calculations, not personalized investment advice, valuation conclusions, trade instructions, or predictions. Bond examples here are hypothetical illustrations of standard mechanics. Consult a qualified professional for advice about your own situation.