How it works
Three numbers describe a plain bond. The face value is the amount repaid at the end. The coupon is the interest paid each year, stated as a percentage of the face value. The maturity is the date on which the face value is repaid.
Once issued, a bond trades at whatever price buyers and sellers agree. Its payments are fixed, so its price is the only thing that can change, and it changes with the interest rate available elsewhere. If new bonds pay 6% and an old one pays 4%, nobody will pay full price for the old one: its price falls until its fixed payments give a buyer about the same return as a new bond. If rates fall instead, the old bond’s price rises.
The arithmetic is called present value. A payment due in some years is worth less today than the same amount paid now, because money held now could earn interest in the meantime. Each payment is divided by (1 + rate) once for every year until it arrives, and the bond’s price is the sum. A higher rate makes every divisor larger and the price smaller.
The further away the payments, the more times they are divided, so a long bond’s price moves more than a short bond’s for the same change in rates. The return a buyer gets from a bond bought at today’s price and held until it is repaid is called its yield to maturity.
What it costs
- The spread between buying and selling prices, which for many bonds is wider than for shares and is often the whole of the dealing cost.
- Accrued interest: a buyer pays the seller the interest that has built up since the last coupon date.
- Fund charges, when bonds are held through a fund rather than directly.
- Tax on the interest received, which differs by country and by type of bond.
The risks
- Interest-rate risk: when market rates rise the price falls, and a long bond falls furthest.
- Credit risk: the borrower may pay late or not at all. A higher yield is usually the market’s price for a higher chance of this.
- Inflation risk: fixed payments buy less if prices in the shops rise faster than expected.
- Liquidity risk: some bonds trade rarely, and can be sold quickly only at a poor price.
- Currency risk, for a bond that pays in another currency.
Where people go wrong
- Believing a bond cannot lose money. Sold before maturity, it fetches the market price, which may be well below what was paid.
- Confusing the coupon with the yield. The coupon is fixed when the bond is issued; the yield depends on the price paid for it.
- Reaching for the highest yield without asking why it is high.
- Assuming a bond fund behaves like one bond. A fund has no maturity date on which the money comes back; it keeps buying new bonds, and its price moves with rates indefinitely.
- Forgetting inflation: a fixed payment for twenty years is a fixed number, not fixed buying power.
Questions people ask
- Why do bond prices fall when interest rates rise?
- A bond’s payments are fixed. When new bonds offer a higher rate, an older bond with lower payments is worth less to a buyer, so its price falls until its return matches what is available elsewhere. The reverse happens when rates fall.
- What is the difference between a bond’s coupon and its yield?
- The coupon is the fixed interest the bond pays each year, as a percentage of its face value. The yield is the return to someone who buys at today’s price. If the price is below face value the yield is higher than the coupon; if it is above, the yield is lower.
- If a bond is held to maturity, does the price in between matter?
- If the borrower pays everything on time, the holder receives the coupons and the face value whatever the price did in between. The price matters if the bond has to be sold early, and the holder has still given up the higher rate that became available elsewhere.
The words on this page
A general explanation for study, with invented examples. Costs, taxes and rules differ by country, market and product, and the documents of the thing itself are what count. Educational information, not investment advice or a recommendation to trade.