A bond is essentially a loan you make to a government or company in return for regular interest and the promise of your money back on a set date. Bonds are the workhorses of the fixed-income world, prized for steady payments and stability. This guide breaks down the parts of a bond and how each one pays you.
The anatomy of a bond
Every bond has a few core features: the par value, also called face value, usually $1,000, which is repaid at the end; the coupon rate, the fixed annual interest percentage; and the maturity date, when the loan comes due. The issuer promises to pay the coupon on schedule and return the par value at maturity. Together these terms are set when the bond is issued. Knowing them tells you exactly what cash you are owed and when.
How coupon payments work
The coupon rate applied to par value determines your interest income. A $1,000 bond with a 4% coupon pays $40 per year, typically split into two $20 payments every six months. These payments are fixed for the life of the bond regardless of what markets do, which is why bonds are called fixed income. At maturity you receive the final coupon plus your $1,000 back, and that predictability is the whole appeal.
Yield versus coupon
The coupon is fixed, but a bond's yield depends on the price you actually pay. If you buy a bond for less than par, your effective yield is higher than the coupon, while paying more than par makes it lower. Yield to maturity captures the total return if you hold the bond to the end, including price and coupons. This is why two bonds with the same coupon can offer very different yields.
Types and risks
Bonds come from many issuers, including governments, municipalities, and corporations, each with different risk and tax treatment. The main risks are credit risk, that the issuer defaults; interest-rate risk, that rates rise and prices fall; and inflation risk, that fixed payments lose buying power. Credit ratings grade default risk, and lower-rated high-yield bonds pay more to compensate. Safer bonds pay less but return your principal more reliably.
You buy a $1,000 bond with a 4% coupon maturing in 10 years. Each year you collect $40 in interest, usually as two $20 payments, and at the end of 10 years you receive your $1,000 back. Over the decade you earn $400 in coupons plus the return of principal.
Key takeaways
- A bond is a loan to an issuer that pays fixed interest and returns par value at maturity.
- Par value is usually $1,000, and the coupon rate sets the annual interest.
- A 4% coupon on a $1,000 bond pays $40 a year, often in two installments.
- Yield depends on your purchase price, not just the coupon.
- Key risks are default, rising rates, and inflation eroding fixed payments.
Common mistakes
- Assuming bonds cannot lose value when their prices fall as rates rise.
- Reaching for high-yield bonds without weighing their higher default risk.
- Confusing a bond's fixed coupon with its yield, which depends on price.
FAQ
What happens if I sell a bond before maturity?
You receive the current market price, which may be above or below par depending on interest rates, so you can gain or lose.
Are government bonds risk-free?
High-quality government bonds carry very low default risk, but they still face interest-rate and inflation risk.