A bond is a loan you make to a government or a company. In return for your money, the borrower promises to pay you interest on a set schedule and to return the original amount on a specific future date. Where a share of stock makes you a part-owner of a business, a bond makes you a lender — with a contractual claim to be repaid rather than a stake in the profits.
That simple structure is the source of a bond’s appeal: predictable income and, for high-quality issuers, a strong likelihood of getting your principal back. It’s also the source of the one idea that confuses most beginners — why a bond’s price falls when interest rates rise.
The three numbers that define a bond
Every bond is described by a handful of terms:
- Face value (or par) — the amount the issuer repays at the end, commonly $1,000 per bond.
- Coupon — the interest rate the bond pays on its face value. A 5% coupon on a $1,000 bond pays $50 a year, typically in two $25 installments.
- Maturity — the date the loan ends and the face value is returned. It can range from months to thirty years or more.
Hold a sound bond to maturity and, barring default, you collect every coupon along the way and your principal at the end. The coupon is fixed for the life of the bond — which is exactly why its market price has to move.
Why price and yield move inversely
A bond’s coupon is locked in, but prevailing interest rates in the economy are not. When new bonds are issued at higher rates, your older, lower-coupon bond becomes less attractive — so to sell it, you’d have to drop the price until its effective return matches what buyers can get elsewhere. When rates fall, the reverse happens and your higher-coupon bond becomes more valuable. Price and yield move in opposite directions, always.
A bond’s coupon is fixed, but the world’s interest rates are not. The price is simply what the market must discount the bond to so its return keeps pace with newer bonds.
A concrete example. You own a $1,000 bond paying a 4% coupon, or $40 a year. Rates then rise and new $1,000 bonds pay 5%, or $50. No one will pay you full price for $40 a year when $50 is available, so your bond’s price slips below $1,000 until its yield — the return based on the discounted price — lines up near 5%. The $40 coupon never changed; the price did the adjusting. These figures are illustrative.
Interest-rate risk and other risks
This price sensitivity is called interest-rate risk, and it matters most if you might sell before maturity. Longer-dated bonds are more sensitive: the further away the repayment, the more a change in rates swings the price. That’s why a 30-year bond can move far more violently than a 2-year one for the same shift in rates.
Two other risks round out the picture:
- Credit (default) risk — the chance the issuer can’t pay. Ratings agencies grade this, and lower-rated issuers must offer higher yields to compensate.
- Inflation risk — because most coupons are fixed, rising prices erode the real value of the income and the principal you’ll get back.
The role bonds play in a portfolio
Investors hold bonds mostly for stability and income, not for the big growth they might expect from stocks. Because high-quality bonds often behave differently from stocks — sometimes holding up when equities fall — they can cushion a portfolio’s swings and provide reliable cash flow.
The classic trade-off is that lower risk tends to come with lower expected returns. Stocks have historically offered higher long-run growth but with sharper drops; bonds offer steadier, more modest returns. Many portfolios blend the two so the mix matches the investor’s time horizon and tolerance for volatility, leaning more toward bonds as the money is needed sooner. None of these historical patterns guarantee future results.