Foundationsexplainers
How Bonds Work: Lending to Governments and Companies
Learning objectives
- Explain what a bond is
- Describe the coupon-yield-price relationship
- Explain why bond prices fall when rates rise
- Distinguish government from corporate bonds
A loan, sliced and tradable
A bond is a standardized IOU: the issuer borrows money and promises periodic interest (the coupon) plus repayment of principal at maturity. Unlike a bank loan, bonds trade on markets, so their prices move daily. Governments issue them to fund deficits; companies issue them to finance investment without diluting shareholders.
When market interest rates rise, existing bonds' fixed coupons look worse, so their prices fall — and vice versa.
Coupons, yields, and maturity
The coupon is the fixed annual payment as a percent of face value; the yield is what you actually earn given the price you pay. Buy at a discount and your yield exceeds the coupon; buy at a premium and it trails. Longer maturities swing more with rate changes — a property called duration that risk managers watch closely.
Why prices move
Two forces dominate: interest rates (the seesaw above) and credit risk (fear the issuer won't pay). Inflation erodes fixed payments, so inflation scares hurt bonds too. That is why bonds — supposedly 'safe' — can lose value sharply when rates spike.
Agencies grade creditworthiness from AAA down to junk; lower grades must offer higher yields to attract buyers.
Bonds in a portfolio
Investors hold bonds for steadier income and diversification — bonds often zig when stocks zag, though not always. Understanding the price-yield seesaw is the single most useful bond concept for reading financial news. This is educational content, not investment advice.
This article explains bond mechanics. It is not investment advice.
Key points
- A bond = tradable loan with coupon payments and principal at maturity
- Bond prices and market yields move in opposite directions
- Longer maturity = bigger price swings (duration)
- Credit risk and inflation are the other price drivers
- Ratings summarize default risk from AAA to junk
Common misconceptions
✓ Truth: Even government bonds carry interest-rate and inflation risk; corporate bonds add default risk.
✓ Truth: Yield depends on the price paid — only buyers at face value earn exactly the coupon rate.
✓ Truth: Existing bond prices fall when rates rise; only new buyers benefit.
Frequently asked questions
Why do bond prices fall when interest rates rise?
New bonds offer higher coupons, so existing fixed-coupon bonds must get cheaper to offer competitive yields.
What is the difference between coupon and yield?
Coupon is the fixed payment rate; yield is the actual return given the market price paid.
What is duration?
A measure of a bond's price sensitivity to rate changes — roughly, the weighted time to receive cash flows.
Are government bonds always safest?
They carry the least default risk in their own currency, but still face interest-rate and inflation risk.