What Is a Bond? Fixed Income Explained

The Basic Structure

When a government or corporation needs to raise money, it can borrow from investors by issuing bonds. A bond is a debt instrument with three key components: the principal (the amount borrowed, also called face value or par value), the coupon (the periodic interest payment, expressed as a percentage of face value), and the maturity date (when the principal is repaid).

For example, a 10-year Treasury bond with a $1,000 face value and a 4% coupon pays $40 per year (typically in two $20 semi-annual payments) and returns $1,000 at the end of 10 years. The investor's total return depends on the purchase price, the coupon payments received, and whether the bond is held to maturity.

Yield vs. Coupon Rate

The coupon rate is fixed at issuance. The yield changes as the bond's market price changes. If you buy a bond at a discount (below face value), your yield is higher than the coupon rate because you will receive the full face value at maturity. If you buy at a premium (above face value), your yield is lower.

The yield to maturity (YTM) is the total annualized return if you hold the bond to maturity and reinvest all coupon payments at the same rate. It is the most complete measure of a bond's return and the standard for comparing bonds.

Credit Risk

Not all bonds are equally safe. Credit risk is the risk that the issuer will fail to make promised payments — a default. Credit rating agencies (Moody's, S&P, Fitch) assign ratings to bond issuers. Bonds rated BBB- or above (S&P) are considered investment grade. Bonds rated below that threshold are called high-yield or junk bonds — they offer higher yields to compensate for higher default risk.

U.S. Treasury bonds are considered the lowest-risk bonds in the world because they are backed by the full faith and credit of the U.S. government. Corporate bonds carry more risk and therefore offer higher yields. Municipal bonds, issued by state and local governments, often offer tax advantages.

Duration and Interest Rate Risk

Duration measures a bond's sensitivity to interest rate changes. A bond with a duration of 7 years will lose approximately 7% of its value if interest rates rise by 1 percentage point. Longer-maturity bonds have higher duration and are more sensitive to rate changes. Short-term bonds are less sensitive.

This is why rising interest rates hurt bond prices — and why long-term bonds are riskier in a rising-rate environment than short-term bonds, even though they offer higher yields.

Educational Context

This article is for educational purposes only and does not constitute investment advice. Bond investing involves risks including interest rate risk, credit risk, and inflation risk.