Bond Basics — Lending Money on a Known Schedule

A bond is a loan with a schedule. The buyer lends money to a government or company, the issuer agrees to pay interest at set intervals, and the principal is returned on a stated maturity date. Where a stock is ownership with an open-ended outcome, a bond is a contract with a defined stream of payments, which is why bonds are usually described as the more predictable side of a portfolio.

The three numbers

A bond is largely described by three figures. The face value is the amount repaid at maturity. The coupon is the interest rate the issuer pays on that face value. The maturity is the date the principal comes back. A ten-year bond with a 4 percent coupon on a 1,000-dollar face value pays 40 dollars a year until year ten, then returns the 1,000. The predictability of that schedule is the product.

Why prices move

Bond prices move opposite to prevailing interest rates. When new bonds are issued at higher rates, an existing bond paying a lower coupon becomes less attractive and its market price falls; when rates drop, the older higher-coupon bond becomes more valuable and its price rises. A holder who keeps a bond to maturity and is repaid still receives the agreed schedule, but a seller before maturity faces whatever the market price is that day. Longer maturities swing more for a given rate change.

The risks that remain

Two matter most. Interest-rate risk is the price movement just described. Credit risk is the chance the issuer fails to pay, which is why a US Treasury and a shaky corporate bond can offer very different yields for the same maturity — the extra yield is compensation for the extra risk. Bonds sit in the framework as a different function from cash and from growth holdings, a distinction the framework reference covers.

The Obsidian Metrics community works through this material weekly.

Educational only. Not financial advice. Results not guaranteed. We are not financial advisors.