Bond

How a bond works

The mechanics in plain terms: you (the lender) hand the issuer money today. The issuer agrees to pay you periodic interest at a fixed rate (the coupon) for the life of the bond, then return the original amount (the par value, or face value) at maturity.

A typical example: a 10-year US Treasury issued at par with a 4% coupon. Buy $10,000 of par value today, receive $200 every six months for 10 years (4% annualized), and get the $10,000 back at maturity.

If you hold to maturity and the issuer doesn't default, your return is fully predictable. This is the appeal of bonds — and why "fixed income" is the broader category name.

Bond prices and yields move opposite

Once issued, bonds trade in secondary markets. Their prices change as prevailing interest rates change, but their coupons don't. The result: bond prices move inversely to rates.

If you own a 4% bond and new equivalent bonds start being issued at 6%, no one wants your bond at face value — they could buy a new one with a higher coupon. Your bond's price drops until its yield (coupon plus capital gain to maturity) matches the 6% market rate.

This is the central mechanic of bond investing. Long-duration bonds are extremely sensitive to rates: a 30-year Treasury can drop 20%+ in value when long rates rise a couple of percentage points. The 2022 bond bear market — driven by the Fed's rapid rate hikes — gave many bond investors their worst year in decades, with long Treasuries down 30%+.

Types of bonds

The major categories:

• Treasury bonds — US government debt. Considered the global benchmark for "risk-free" interest rates (default risk is essentially zero, though price risk on long-duration bonds is real).
• Corporate bonds — issued by companies. Pay higher yields than Treasuries to compensate for default risk. Split into investment-grade and high-yield (junk) by credit rating.
• Municipal bonds — issued by US state and local governments. Interest is typically exempt from federal tax, often state tax too.
• Sovereign bonds — non-US government debt. Default risk varies sharply by country.
• Mortgage-backed and asset-backed securities — pools of underlying loans packaged into tradable bonds. The 2008 crisis was largely a mortgage-backed-securities crisis.
• Convertible bonds — corporate bonds that can be converted to stock under specified conditions; combine fixed-income and equity exposure.

Why bonds belong in a portfolio

Two main reasons most diversified portfolios hold bonds:

• Income — predictable cash flow, useful for retirees and income-focused investors.
• Diversification from stocks — historically, bonds have moved in different patterns than stocks, particularly in equity bear markets when investors flee to Treasuries. The classic 60/40 stock/bond portfolio expresses this.

The 2022 episode was a notable exception: stocks and bonds fell together because both were sensitive to rapidly rising rates. The historical pattern reasserted in subsequent years, but it's a useful reminder that the diversification isn't perfect.

Key risks

• Interest rate risk — covered above. Magnified by duration.
• Credit risk — the issuer might default. Highest for high-yield corporate, lowest for Treasuries.
• Inflation risk — fixed coupons lose purchasing power if inflation rises. TIPS (Treasury Inflation-Protected Securities) hedge this directly.
• Reinvestment risk — coupons received during the bond's life have to be reinvested, potentially at lower rates.
• Liquidity risk — most corporate and municipal bonds trade in dealer markets with wider bid-ask spreads than stocks. Selling during stress can mean accepting meaningful price concessions.

How most people own bonds

Direct ownership of individual bonds is common for institutions and wealthy individuals; for typical investors, ETFs and mutual funds provide diversified bond exposure with low fees. The Bloomberg US Aggregate Bond Index is the standard benchmark for US investment-grade bonds, tracked by funds like AGG and BND. International, high-yield, TIPS, and sector-specific bond funds round out the available exposures.