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How Bonds Work
Example: Government bond
You buy a $1,000 Treasury bond at 4% interest maturing in 10 years.
- You pay: $1,000
- Annual interest: $40/year (4% of $1,000)
- At maturity (year 10): Receive $1,000 principal
- Total paid to you: $400 in interest + $1,000 principal = $1,400
This is straightforward lending: you know exactly what you'll receive.
Bond Components
Face value (par value): The amount borrowed. Usually $1,000.
Coupon rate: The interest rate paid. A 4% coupon means 4% of face value annually.
Maturity: When the loan ends. 2-year, 10-year, 30-year bonds.
Coupon payment frequency: Usually semi-annually. A 4% annual coupon pays $20 twice yearly.
Bond Pricing and Interest Rates
Bond prices fluctuate based on interest rates:
Example: You own a $1,000 bond paying 4% interest ($40/year)
Interest rates fall to 2%:
- New bonds pay only 2% ($20/year)
- Your 4% bond ($40/year) is more valuable
- Someone will pay premium for it (say $1,200) to get $40/year
- Your bond rises in price
Interest rates rise to 6%:
- New bonds pay 6% ($60/year)
- Your 4% bond ($40/year) is less valuable
- You must discount it (say $800) for someone to accept lower return
- Your bond falls in price
Key relationship: Interest rates up → bond prices down | Interest rates down → bond prices up
Bond Types
Government bonds:
- Issued by governments
- Backed by taxation power
- Very safe (U.S. government default is nearly impossible)
- Low interest rates (3-5%)
Corporate bonds:
- Issued by companies
- Backed by company cash flows
- Risk varies by company (Apple's bonds safer than startup's)
- Higher rates (4-7%)
High-yield bonds (junk bonds):
- Issued by risky companies
- High default risk
- High interest rates (8-12%)
- Can lose significant value if company defaults
Yield vs. Coupon
Coupon: The stated interest rate (4%)
Yield: The actual return based on current price
Example: $1,000 bond, 4% coupon, current price $800
- Coupon: 4% ($40/year)
- Yield: $40 ÷ $800 = 5%
Yield is what matters to buyers. If you buy at $800, you get a 5% yield (not 4%).
Duration: Bond Sensitivity to Rates
Duration measures how sensitive a bond is to interest rate changes.
Example:
- Short-duration bond (2-year maturity): Falls 2% if rates rise 1%
- Long-duration bond (30-year maturity): Falls 15-20% if rates rise 1%
Longer-term bonds are riskier in rising-rate environments (more price decline).
Bonds and Portfolio Risk
Bonds reduce portfolio volatility because they're negatively correlated with stocks:
Stock market crashes (bad for stocks):
- Economic weakness likely → rates fall
- Falling rates mean bond prices rise
- Bonds offset stock losses
Stock market booms (good for stocks):
- Economic strength likely → rates rise
- Rising rates mean bond prices fall
- Bonds provide modest drag
A 60/40 stock/bond portfolio is much less volatile than 100% stocks, even though returns are slightly lower.
Default Risk
Government bonds: Nearly zero default risk (governments can print money)
Investment-grade corporate bonds: Low default risk (<1% annually)
High-yield bonds: Significant default risk (3-5% annually)
During recessions, corporate bond defaults rise. A 6% high-yield bond is less attractive if it has a 5% default risk.
Credit Ratings
Credit rating agencies (S&P, Moody's, Fitch) rate bond safety:
AAA: Highest quality (Apple, Microsoft, U.S. government) AA: Very high quality A: High quality BBB: Investment grade (still safe) BB and below: Speculative (high-yield junk bonds)
Ratings affect yields: AAA bonds pay 3-4%; BB bonds pay 8-10%.
Bond Fund vs. Individual Bonds
Individual bonds:
- You know exactly what you'll receive at maturity
- Can hold to maturity, avoiding price risk
- Requires management (picking which bonds to buy)
- Minimum usually $1,000-5,000 per bond
Bond funds/ETFs:
- Professional management
- Diversification across many bonds
- Can liquidate anytime (but prices fluctuate)
- Low investment minimums ($1 for ETFs)
- Pay ongoing fees (0.03-1.00%)
Most individual investors should use bond ETFs for simplicity and diversification.
Historical Bond Returns
Bonds' lower return is offset by lower risk. A diversified portfolio with stocks and bonds balances growth with stability.
Bonds in Current Environment
Bond yields change with interest rates:
Low-rate environment (2020): Bonds yielding 0.5-2%
High-rate environment (2024): Bonds yielding 4-5%
When rates are high, bonds become attractive. When rates are near zero, bond yields are unattractive.
The Bottom Line
Bonds are lower-risk, lower-return investments that provide income and portfolio stability. Government bonds are safest; corporate bonds offer higher yields for taking on credit risk. Bonds are especially valuable in stock-heavy portfolios, where they provide stability and negatively correlate with stocks.
For most investors, diversified bond funds are the best approach to adding bond exposure.
