Bonds explained: coupons, yields and why prices move

What bonds are, how coupons and yields work, why bond prices fall when interest rates rise, with a worked example, plus credit risk and duration.

Part of the Investing Foundations track on Agenticks. About 11 minutes, written for a beginner reader.

Read first: What is investing (and what it is not).

Last reviewed .

Key takeaways

A bond is a loan. When you buy one, you are lending money to the borrower, called the issuer, which might be a national government, a city or a company. In return the issuer usually promises two things: regular interest payments, and the return of the original amount on a set date. That makes a bond different from a stock. A share of stock is a slice of ownership, with no promised payments and no end date. A bond is a contract with fixed terms. You know in advance what it is meant to pay and when, and the risks come from two questions: will the borrower actually pay, and what happens to the bond's price before it does?

Every bond is described by a few terms. Face value, also called par or principal, is the amount the issuer repays at the end. Many bonds are issued in units of $1,000. The coupon is the yearly interest, set as a percentage of face value. A 4% coupon on a $1,000 bond pays $40 a year, often as two payments of $20. Maturity is the date the face value is repaid and the loan ends. It can be months away or 30 years away. The yield is the return as a yearly percentage of the price you actually pay. Current yield is the yearly coupon divided by the price. Yield to maturity also counts the gain or loss from paying more or less than face value and holding until it is repaid. If you buy a bond at exactly its face value, the coupon and the yield are the same number. They only drift apart once the bond's price moves, and that is where most of the interesting behaviour comes from.

Rates up, prices down

Market interest rates and the prices of existing fixed-rate bonds move in opposite directions. A bond's coupon is locked in. When new bonds start paying more, nobody will pay full price for an old bond that pays less, so its price drops until its yield is competitive again.

Here is that seesaw with real arithmetic. The bond pays its coupon once a year to keep the sums readable; many real bonds pay twice a year, which changes the figures slightly but not the idea.

Worked example: a 4% bond when rates rise to 5%

You buy a new 10-year bond for its $1,000 face value. It pays a 4% coupon. Shortly afterwards, market rates for similar new bonds jump to 5%.

Your bond's yearly coupon (4% x $1,000)$40
A new bond's yearly coupon at 5% (5% x $1,000)$50
Price at which your bond also yields 5% to a buyer (ten $40 coupons plus $1,000 at the end, each discounted at 5% a year)about $923
Change in your bond's price (923 / 1,000 - 1)about -7.7%
Current yield for the new buyer (40 / 923)about 4.3%
Same rate rise on a 2-year 4% bond (40/1.05 + 1,040/1.05^2)about $981, or -1.9%
Longer bond, bigger fall-7.7% for 10 years vs -1.9% for 2 years

Illustrative numbers. If rates had fallen to 3% instead, the same 10-year bond would be worth about $1,085.

Notice what did not change. Your bond still pays $40 a year, and if you hold it for the full 10 years and the issuer pays, you still get your $1,000 back. The loss is only realised if you sell before maturity. The Investor.gov bulletin on this makes the same point with a Treasury example: a 3% bond falls to about $925 when market rates move to 4%. The example also shows why maturity matters. The 2-year bond barely moved because it repays its face value soon, so its below-market coupon only matters for two years. The 10-year bond is stuck with that coupon for ten. Longer maturities and lower coupons both make a bond more sensitive to rate changes.

Professionals sum up that sensitivity with a number called duration, stated in years. As a rough rule, a bond or bond fund with a duration of 8 falls about 8% if rates rise by one percentage point, and rises about 8% if they fall by one. The 10-year bond in the example has a duration of a little over 8, which is why a one-point rise cost it close to 8%. A bond fund never matures, because it keeps replacing the bonds it holds, so its duration is the most useful single clue to how much it will swing when rates move.

The second big risk is credit risk: the chance that the issuer fails to pay interest or repay the face value on time, which is called a default. Rating agencies grade borrowers to give a quick sense of that risk. On the scale used by S&P, bonds rated BBB or better are called investment grade, and those rated BB or lower are called high yield. Lower-rated borrowers have to offer higher yields to attract lenders, so a bond paying far more than similar bonds is usually telling you something about its risk. A rating is an opinion, not a promise, and it can be cut. That leads to the broad split between government bonds and corporate bonds. Bonds from national governments with their own currency, such as US Treasuries, Government of Canada bonds and UK gilts, are generally treated as having very low default risk. Corporate bonds pay more because companies can and do fail. But low default risk is not the same as no price risk. Even government bonds fall in price when rates rise, because the government guarantees the payments, not the market price if you sell early.

A few more risks are worth knowing by name. Inflation risk: a fixed $40 a year buys less each year that prices rise, so a long bond can lose real value even if every payment arrives on time. Call risk: some bonds let the issuer repay early, which issuers tend to do after rates have fallen, so you get your money back just when reinvesting it pays less. Liquidity risk: some bonds trade rarely, so selling before maturity can mean waiting for a buyer or accepting a lower price. Bond funds spread credit risk across many issuers and are easy to buy and sell, but as the duration section showed, they still rise and fall with interest rates.

So why do so many portfolios hold bonds? Mainly for predictable income and steadier behaviour. Bonds usually swing less than stocks, and their regular payments can help offset the ups and downs of a stock-heavy mix. They are not a guarantee of that: inflation eats into fixed payments, and there have been stretches when stocks and bonds fell together. How much of each to hold is the subject of asset allocation, and it ties straight back to the risk and return tradeoff.

Coupon
The fixed yearly interest, as a percentage of face value
Face value
The amount repaid when the bond matures
Yield
The return as a yearly percentage of the price you pay
Duration
How sensitive the price is to a change in rates, in years
Credit rating
An agency's grade of how likely the borrower is to pay

Market rates fall from 4% to 3%. What happens to the price of the 10-year 4% bond in the worked example? It rises, to about $1,085 Its $40 coupon now beats the $30 that new bonds pay, so buyers will pay more than face value for it.

You can read a bond

You know what a coupon, face value, maturity and yield are, why prices fall when rates rise, why longer bonds move more, and what credit ratings tell you.

Check your understanding

A $1,000 bond has a 3% coupon. How much interest does it pay each year?
$30. The coupon is a percentage of face value: 3% of $1,000 is $30 a year, whatever the bond's price.
Market interest rates rise from 4% to 5%. What usually happens to the price of an existing bond paying a 4% coupon?
It falls, so its yield moves closer to the new 5%. New bonds pay 5%, so a buyer will only take the 4% bond at a lower price.
Two bonds from the same issuer have 4% coupons. One matures in 2 years, the other in 10. Rates rise by one point. Which falls more?
The 10-year bond. In the worked example the 10-year bond fell about 7.7% and the 2-year about 1.9%. Longer bonds are more sensitive.
Why does a bond rated BB usually pay a higher yield than a similar bond rated AA?
Lenders want extra return for a higher chance of default. BB is below investment grade, so the borrower must pay more to attract lenders.

Common questions

What is a bond in simple terms?
A bond is a loan you make to a government or a company. In return, the borrower usually pays you interest, called the coupon, on a set schedule and repays the original amount, called the face value, on a set date called maturity.
Why do bond prices fall when interest rates rise?
Most bonds pay a fixed coupon. When new bonds start paying more, an older bond with a lower coupon is less attractive, so its price falls until its yield roughly matches what new bonds pay.
Can you lose money on bonds?
Yes. A bond sold before maturity can fetch less than you paid if rates have risen, and a borrower can default. If you hold a bond to maturity and the issuer pays in full, you receive the face value and the coupons.

Terms defined in this lesson

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Agenticks Learn is general education. It is not financial, investment, tax or legal advice, it does not take your situation into account, and nothing on it is a recommendation to buy, sell or hold any security or to open any account. Examples use illustrative numbers. Investing involves risk, including losing money you put in, and past performance does not predict future results. Tax rules and limits change; the official sources linked in each lesson are the final word.