What Is a Bond? How Lending to Governments and Companies Works

A bond is a loan you can sell to someone else. That is the whole idea, and almost everything else follows from it.

The bond market is larger than the stock market, and it sets the interest rates underneath mortgages, corporate borrowing and government spending. Understanding it explains a great deal of financial news that otherwise reads as noise.

The four things that define a bond

Face value (or par). The amount repaid at the end, conventionally 1,000 or 100.

Coupon. The fixed interest paid, usually annually or semi-annually, expressed as a percentage of face value. A 4% coupon on a 1,000 bond pays 40 a year — and keeps paying exactly 40 regardless of what happens to interest rates, the economy or the bond's price.

Maturity. When the face value is repaid and the bond ceases to exist. Anything from months to thirty years or more.

Issuer. Who owes you the money. A government, a company, a municipality.

That's it. A bond is a schedule of fixed payments and a repayment date.

Why the price moves

Here is the part that confuses people, and it resolves with one example.

You own a bond paying 40 a year, maturing in ten years, that you bought for 1,000. Your yield is 4%.

Interest rates in the economy rise. New bonds of similar quality now pay 60 a year. Nobody will buy your bond for 1,000 when they can get 60 elsewhere for the same money.

So your bond's price falls — to roughly 850, say. At that price, a buyer receives 40 a year on an outlay of 850, plus a gain to 1,000 at maturity. Their total return now matches the 6% available elsewhere.

Nothing about your bond changed. The payments are identical. Only the price adjusted, because the alternative got better.

This is the inverse relationship: when yields rise, prices fall. They are two descriptions of one thing.

Coupon versus yield

	Coupon	Yield
Set when	At issue, permanently	Continuously, by the market
Based on	Face value	The price you actually pay
Changes?	Never	Constantly

A bond is often described by its coupon and traded on its yield. When news reports "the ten-year yield rose", it is describing the return available to a new buyer, not a change to anyone's coupon.

Duration: how much the price will move

Duration measures price sensitivity to interest rate changes, expressed in years.

The rough rule: a bond with duration of 8 falls about 8% in price if yields rise one percentage point.

Maturity	Approximate duration	Price change if yields rise 1%
2 years	~1.9	−1.9%
5 years	~4.5	−4.5%
10 years	~8.5	−8.5%
30 years	~19	−19%

This is why long-dated bonds are volatile despite being "safe". A thirty-year government bond carries no meaningful default risk and can still lose a fifth of its value in a year if yields rise sharply. Investors who equated "government bond" with "no risk" have discovered this expensively.

The two risks that matter

Credit risk — the issuer fails to pay. Governments borrowing in their own currency can always create that currency, so default risk is minimal (inflation risk replaces it). Companies genuinely can fail, which is why corporate bonds pay more.

Rating agencies grade this, broadly splitting bonds into investment grade and high yield (historically called junk). The extra yield above a government bond of the same maturity is the credit spread, and it widens when markets expect trouble — often before equity markets react, which makes it a useful early indicator.

Interest rate risk — yields rise and your price falls, as above. Unavoidable if you might sell before maturity.

A third worth naming: inflation risk. Fixed payments lose purchasing power. A 3% coupon during 5% inflation loses you value every year in real terms, even though the payments arrive exactly as promised.

Why bonds matter even if you never buy one

Government bond yields are the reference rate for almost everything:

• Mortgages are priced off long-term yields plus a margin.
• Company borrowing is priced off them plus a credit spread.
• Share valuations discount future earnings at a rate anchored on them.
• Pension funds value their obligations using them, which is why falling yields create pension deficits.

When the ten-year yield moves sharply, everything reprices around it. A great deal of "shares fell today for no obvious reason" is explained by a bond market move.

Ways to hold them

Individual bonds — you know the exact payments and the date you get your capital back, if you hold to maturity.

Bond funds and ETFs — diversified and liquid, but they never mature. There is no date at which you are guaranteed your capital back, so a fund can sit at a loss for years after a rate shock. This surprises people who bought a bond fund expecting bond-like certainty.

The bottom line

A bond is a fixed schedule of payments. Because the payments are fixed, the only thing that can adjust when conditions change is the price — which is why prices fall as yields rise, and why long-dated bonds swing far more than their reputation suggests.

Understanding that single mechanism explains most bond market news, and a fair amount of stock market news too.

This article is educational and is not financial advice. The value of investments can fall as well as rise.