Bond Definition: A bond is a debt security in which an investor lends money to a government or company for a fixed period in exchange for regular interest payments, called coupons, and the return of the principal at maturity. Because the coupon is fixed, a bond’s market price moves in the opposite direction to interest rates: when rates rise, existing bonds fall in price, and when rates fall, they rise.
What Is a Bond?
When a government needs to fund a budget deficit or a company wants to build a factory without issuing new shares, it borrows by selling bonds. Each bond is an IOU with three numbers printed on it: the face value (the amount repaid at the end, often $1,000), the coupon (the annual interest, as a percentage of face value) and the maturity date (when the loan ends).
Unlike a bank loan, a bond can be sold to someone else before it matures. That turns a private loan into a traded asset with a price that changes every day. Global bond markets are larger than global stock markets, and government bonds are the main tool through which states finance fiscal policy.
Holding a bond to maturity is simple: you collect the coupons and get your principal back, unless the issuer defaults. Trading one is where the complexity starts, because its price depends on what newer bonds pay.
How Do Bond Prices and Yields Work?
A bond’s yield is the annual return you earn if you buy at today’s price and hold to maturity. Price and yield move inversely because the coupon never changes. If market interest rates rise above the coupon, nobody pays full price for the old bond, so its price drops until its yield matches what new bonds offer.
Take a 10-year bond with a $1,000 face value and a 3% coupon, paying $30 a year. You buy it at $1,000, and a month later rates on comparable bonds jump to 4%.
A new buyer can now get $40 a year elsewhere, so they will pay only about $919 for your $30 bond. At that price, the $30 coupons plus the $81 gain at maturity add up to a 4% yield. Your paper loss is 8%, even though the issuer has not missed a single payment.
How far the price moves depends on duration, a measure of how sensitive a bond is to rate changes. Longer maturities mean higher duration. A 30-year bond with a low coupon might lose 17% or more on the same one-point rise that costs a two-year note less than 2%.
Types of Bonds
- Government bonds are issued by national treasuries, such as US Treasuries, German Bunds or UK gilts. Bonds from stable governments borrowing in their own currency carry the lowest default risk.
- Corporate bonds are issued by companies and pay more than government bonds to compensate for the risk that the company fails. Those rated below investment grade are called high-yield or junk bonds.
- Municipal bonds fund local governments and public projects such as schools and roads.
- Inflation-linked bonds, such as US TIPS, adjust their principal with consumer prices to protect investors from inflation.
- Zero-coupon bonds pay no interest along the way and are sold at a discount to face value instead.
Bond vs. Stock
| Bond | Stock | |
|---|---|---|
| What you own | A loan to the issuer | A share of the company |
| Income | Fixed coupons set at issue | Dividends, which can be cut or raised |
| Maximum gain | Limited to coupons plus any price gain | Unlimited |
| In bankruptcy | Paid before shareholders | Paid last, often nothing |
| Main price driver | Interest rates and credit quality | Earnings and growth expectations |
Why Are Bonds Important for Traders?
Government bond yields are the benchmark for pricing almost everything else. Mortgage rates, corporate borrowing costs and stock valuations all start from the yield on a safe government bond, because that is what an investor can earn without taking credit risk. When the 10-year Treasury yield rises, the future earnings of growth companies are worth less today, which is why technology stocks often fall on days when yields jump.
Bonds also signal what investors expect from the economy and the central bank. Falling yields usually mean traders expect rate cuts or slower growth. Rising yields reflect expected rate hikes, higher inflation or worries about government debt. Traders often buy government bonds as a hedge, since they tend to rise in price when stocks fall on fears of recession.
That hedge can fail, and the risk is real even for the safest bonds. In 2022, as the Fed raised rates from near zero, the Bloomberg US Aggregate bond index lost about 13%, its worst year on record, while stocks fell at the same time. Silicon Valley Bank showed where rate risk leads: it had put deposits into long-dated Treasuries and mortgage bonds, and when rising rates cut their value and depositors withdrew cash, the bank had to sell at a loss and collapsed in March 2023.
Key Takeaways
- A bond is a tradable loan that pays fixed coupons and returns its face value at maturity, unless the issuer defaults.
- Bond prices and yields move in opposite directions, because a fixed coupon must be repriced when market interest rates change.
- Duration measures rate sensitivity: the longer the maturity, the larger the price swing for each change in rates.
- Government bond yields serve as the benchmark for mortgage rates, corporate borrowing costs and stock valuations.
- Even default-free government bonds can lose double-digit percentages in price when rates rise, so bonds are not a risk-free hedge.
Can you lose money on a bond?
Yes. If you sell before maturity after interest rates have risen, you receive less than you paid, and if the issuer defaults you may lose part or all of the principal. Inflation can also erode the real value of fixed payments.
Why do bond prices fall when interest rates rise?
A bond's coupon is fixed when it is issued. When new bonds start paying more, the old one only finds buyers at a lower price, which raises its effective yield to match the market.
What is a zero-coupon bond?
It is a bond that pays no periodic interest. You buy it below face value and receive the full face value at maturity, so the discount is your return.
Are bonds safer than stocks?
High-quality government bonds held to maturity carry far less risk of loss than stocks, but long-dated bonds can still fall sharply in price when rates rise. Low-rated corporate bonds can be as volatile as shares.
