What it means
A bond has four defining features: the face value or principal, which is repaid at the end; the coupon, which is the interest rate paid on that face value; the maturity date; and the issuer, meaning whoever is borrowing. A government bond and a corporate bond work in the same way, and only the credit risk differs.
The part that confuses newcomers is that the price moves after issue. Once a bond exists paying 4% a year and new bonds are issued paying 6%, nobody will buy the old one at full price, so its market price falls until the return to a new buyer is competitive again.
That inverse relationship is the single most important fact about bonds: when interest rates rise, bond prices fall, and when rates fall, bond prices rise. The longer the remaining life of the bond, the bigger the price move for a given change in rates, a sensitivity measured as duration.
Yield is therefore more useful than the coupon. Current yield compares the annual coupon with the price you actually paid, and yield to maturity goes further by folding in the gain or loss you will make if you hold the bond until it repays at face value.
The risks are worth naming plainly. Credit risk is the chance the issuer does not pay; interest rate risk is the chance rates rise and the price of your bond falls; inflation risk is the chance the fixed payments buy less than you expected; liquidity risk is the chance you cannot sell at a fair price when you want to.
In practice
Real-world examples
Example 1
A city issues $25,000,000 of ten year bonds at a 4% coupon to fund a water treatment plant. Investors receive $25,000,000 x 0.04 = $1,000,000 a year in interest and the principal back in year ten. The city prefers this to a bank facility because it fixes the rate for a decade.
Example 2
A retired investor builds a ladder of bonds maturing in each of the next eight years. One bond repays every year, giving predictable cash for living costs and a chance to reinvest at whatever rates prevail, which avoids committing everything at a single point in the rate cycle.
Example 3
A corporate treasurer holds $8,000,000 of bonds maturing in twelve years and is told rates may rise by a full percentage point. Because the portfolio's duration is high, she sells and reinvests in bonds maturing in two years, accepting a lower yield in exchange for a much smaller price fall if rates do move.
Think of it
Think of a bond like an IOU note from a friend. You give them money now, with the understanding that they will pay you back later, plus a little extra for letting them use your money.
Formula
Calculation
Annual coupon payment = face value x coupon rate
Current yield = annual coupon payment / market price
Approximate yield to maturity = (annual coupon + (face value - price) / years to maturity) / ((face value + price) / 2)
Worked example. A company issues a bond with a face value of $1,000 and a coupon of 6%, maturing in five years, so the annual coupon payment is $1,000 x 0.06 = $60.
Interest rates rise after issue and you buy the bond in the secondary market for $950. Your current yield is $60 / $950 = 0.0632, or 6.32%, higher than the 6% coupon because you paid less than face value.
Yield to maturity adds the $50 capital gain you will make when the bond repays $1,000. Spread over five years that is $50 / 5 = $10 a year, so the numerator is $60 + $10 = $70. The average of face value and price is ($1,000 + $950) / 2 = $975, so the approximate yield to maturity is $70 / $975 = 0.0718, or 7.18%.
Over the full five years you receive $60 x 5 = $300 in coupons plus the $50 gain, a total of $350 on an outlay of $950.Case study
Seen in the real world
Harlow Grange Brewing is an invented company used here as an illustrative example. It needed $20,000,000 for a new bottling line and chose a seven year bond with a 5% coupon rather than a bank facility, mainly because the bond carried no covenants requiring quarterly compliance tests.
The annual interest cost was $20,000,000 x 0.05 = $1,000,000, payable whatever the year brought. Two years in, a poor summer cut operating profit from $4,000,000 to $1,200,000, and although the company still covered the coupon comfortably enough to avoid default, interest cover fell from four times to 1.2 times.
In this fictional account the bonds traded down to around $88 per $100 of face value as investors reassessed the risk, even though no payment had been missed. Harlow Grange's finance director drew the lesson that a bond removes the lender's ability to interfere but not the obligation to pay, and that the market reprices that obligation long before anything actually goes wrong.
Watch out
Common mistakes
- Assuming bonds cannot lose money, when a rise in interest rates cuts the market price of an existing bond immediately and a default can cost the principal entirely.
- Confusing the coupon with the yield, when the coupon is fixed against face value while the yield depends on the price you actually paid.
- Ignoring how long a bond has left to run, since a thirty year bond and a two year bond respond very differently to the same change in interest rates.
Questions
People also ask
What happens if I hold a bond to maturity after its price has fallen?
You receive the face value back regardless of the price movements in between, so an interim loss only becomes real if you sell early.
Are government bonds risk free?
They carry very little credit risk in major currencies, but they still carry interest rate risk and inflation risk, either of which can produce a real loss.
Why would a company issue bonds instead of borrowing from a bank?
Bonds can be larger, longer and carry fewer ongoing conditions, though they require disclosure, usually a credit rating, and repayment of the whole principal on one date.