Bondholders are creditors rather than owners. That distinction affects both return and risk: bonds usually offer contractual cash flows and higher priority than common stock in bankruptcy, but their market value can still fall before maturity.
Key Takeaways
- Debt security: Buying a bond means lending money to the issuer.
- Price and yield move: A fixed coupon does not mean the bond’s market price or yield stays fixed.
- Several risks matter: Interest-rate, credit, inflation, liquidity, and call risk can all affect results.
- Bond type matters: Treasuries, municipal bonds, corporate bonds, and bond funds can have very different tax and risk profiles.
How Bonds Work: Face Value, Coupon, Maturity, and Price
An issuer sells bonds to raise capital. The bond terms specify the principal amount, maturity date, interest structure, and other contractual features. A traditional fixed-rate bond pays a stated coupon and generally returns face value at maturity if the issuer meets its obligations.
| Term | What it means |
|---|---|
| Face or par value | Principal amount generally due at maturity |
| Coupon rate | Stated interest rate used to determine coupon payments |
| Maturity | Date the principal becomes due |
| Market price | Price investors pay when the bond trades after issuance |
| Yield | Return measure that reflects income, price, and sometimes maturity assumptions |
After issuance, a bond can trade above or below par. Investors who sell before maturity receive the market price, not automatically the face value.
Why Bond Prices and Interest Rates Move in Opposite Directions
When market interest rates rise, newly issued bonds can offer more attractive coupons than older fixed-rate bonds. The older bond generally must fall in price to compete. Falling market rates can make an older higher-coupon bond more valuable.
Maturity affects sensitivity. Longer-maturity bonds generally have greater interest-rate risk than otherwise similar shorter-maturity bonds because rates have more time to change before principal is repaid.
Coupon Rate, Current Yield, and Yield to Maturity
The coupon rate is based on the bond’s face value, while current yield compares annual coupon income with the bond’s current market price. Yield to maturity goes further by incorporating price, coupon payments, time to maturity, and repayment of principal under stated assumptions.
A bond bought below par can therefore have a yield higher than its coupon rate, while a bond bought above par can have a lower yield. Comparing bonds by coupon alone can be misleading.
Major Bond Types and Their Trade-Offs
U.S. Treasury securities are obligations of the federal government. Municipal bonds are issued by states, cities, and other public entities and can have special federal or state tax treatment. Corporate bonds depend on the issuing company’s financial strength and generally offer higher yields when credit risk is higher.
Bond terms can also include call provisions that allow the issuer to repay early. That can hurt investors when rates fall because proceeds may need to be reinvested at lower yields.
Bond Risks Beyond Default
Credit risk is only one part of fixed-income risk. Inflation can erode the purchasing power of fixed payments. Liquidity risk can make a bond difficult to sell at a fair price. Interest-rate changes can create market losses. Call risk can shorten the expected investment period.
Bond funds add another layer: they usually do not have one maturity date at which the investor automatically receives a fixed face value. Their NAV changes continuously as portfolio holdings and market rates move.
Bonds vs. Stocks and the Role of Bonds in a Portfolio
A bondholder is a creditor; a stockholder is an owner. Creditors generally rank ahead of common shareholders if a company is liquidated, while shareholders have greater participation in business growth and losses.
Bonds are often used for income, capital preservation, liability matching, or diversification from equity risk. Whether a particular bond serves those goals depends on maturity, credit quality, yield, tax treatment, and the investor’s time horizon—not simply on the fact that it is called a bond.
Frequently Asked Questions (FAQs)
Is a bond basically a loan?
Economically, yes. Buying a bond means lending money to an issuer under contractual terms.
Do bonds always pay regular interest?
No. Zero-coupon bonds, for example, are issued at a discount and do not make ordinary periodic coupon payments.
Can a bond lose money before maturity?
Yes. Interest rates, credit quality, liquidity, call features, and market conditions can reduce its price.