What a bond is
A bond is a loan you make to a government or company in return for interest. Here is how bonds work and why their prices move opposite to yields.
A bond is a loan. When you buy a bond, you lend money to a government or a company. In return, they agree to pay you interest and to repay the full amount on a set date.
The basic parts
Every bond has a few key terms.
- Issuer. The government or company that borrows the money.
- Face value. The amount the issuer will repay at the end. It is also called par value.
- Coupon. The interest the issuer pays, shown as a yearly percentage of the face value.
- Maturity date. The date the loan ends and the face value is repaid.
A simple example
A company issues a bond with a face value of $1,000, a 5% coupon and a maturity of 10 years.
If you hold it the whole time, you receive $50 a year in interest for 10 years. At the end, you get your $1,000 back.
Many bonds pay their interest in two payments a year.
Who issues bonds
- Federal governments. In the US these are Treasury securities. In Canada they are Government of Canada bonds. They are generally considered the safest bonds in each country.
- States, provinces and cities. Local governments borrow to pay for roads, schools and other projects.
- Companies. Corporate bonds usually pay more interest than government bonds because the risk of not being repaid is higher.
Bonds trade after they are issued
You do not have to hold a bond until it matures. Bonds are bought and sold between investors, and their prices change.
This is where many people get confused. The coupon on a bond is fixed. The price is not.
Why prices and yields move in opposite directions
Yield is the return you get on a bond based on the price you pay for it today.
Say you own a bond that pays 4% a year. Then interest rates rise, and new bonds pay 6%. Nobody wants your 4% bond at full price when they can get 6% elsewhere. To sell it, you must accept a lower price. At that lower price, the 4% coupon works out to a higher yield for the buyer.
The reverse is also true. If rates fall, older bonds with higher coupons become more attractive, and their prices rise.
So:
- When yields go up, bond prices go down.
- When yields go down, bond prices go up.
This is why the news often reports bond yields rather than bond prices. You can see how this connects to stocks in how interest rates move stock prices.
Longer bonds move more
A bond with many years left to maturity is more sensitive to rate changes than one that matures soon. Its fixed payments are locked in for longer, so a change in rates matters more to its price.
The risks
Bonds are often seen as steadier than stocks, but they are not risk-free.
- Interest rate risk. Rising rates lower the price of bonds you already own.
- Credit risk. The issuer may fail to pay interest or repay the face value. This is called a default.
- Inflation risk. Rising prices reduce what your fixed payments can buy.
Credit ratings
Credit rating agencies grade issuers on how likely they are to repay. The highest grades go to the most reliable borrowers.
Bonds rated below a certain level are called high-yield or "junk" bonds. They pay more interest to make up for a higher chance of default.
Bonds and the wider market
Government bond yields are watched closely because they affect borrowing costs across the economy, including mortgages and business loans. Central banks such as the Federal Reserve and the Bank of Canada influence short-term rates, while longer yields are set more by the market.
Two widely watched yields are the US 10-year Treasury yield and the Canada 10-year bond yield. The gap between short and long yields is called the yield curve. When it flips, people talk about an inverted yield curve.
How people hold bonds
Some investors buy individual bonds through a broker. Many hold them through bond funds or bond ETFs, which own many bonds at once. A bond fund has no single maturity date, so its value keeps moving with rates.
The short version
- A bond is a loan to a government or company that pays interest.
- The coupon is fixed, but the bond's price changes after it is issued.
- When yields rise, bond prices fall, and the other way around.
- Longer bonds react more to rate changes.
- Bonds carry interest rate, credit and inflation risk.
This is general information, not investment advice.
Updated