What is Bond?

A bond is a loan that you make rather than take. When an investor buys a bond, they lend money to an issuer, such as a national government, a city or a company. In return, the issuer agrees to pay interest at regular intervals, called the coupon. It also agrees to repay the original amount, called the face value or principal, on a fixed date known as maturity. Because the payments are set in advance, bonds are often called fixed income. Bonds issued by the US government are called Treasuries, and the shortest ones, maturing within a year, are Treasury bills.

Say you buy a newly issued 10-year bond for $10,000 with a 4% coupon. Each year you receive 4% × $10,000 = $400. Over ten years that adds up to $4,000 of interest, and at maturity you get your $10,000 back, so $14,000 in total. Now suppose that a year later, new 10-year bonds pay 5%, or $500 a year. No buyer would pay full price for your $400 a year, so the market price of your bond falls until a buyer earns roughly 5% on it. In this hypothetical case the price drops to about $9,300. Prices and interest rates move in opposite directions. If you hold to maturity and the issuer pays, you still receive the full $10,000.

A common misunderstanding is that bonds are safe in every sense. A bond's price can fall sharply when rates rise, and the longer the time to maturity, the bigger the move. This sensitivity is measured by duration, roughly the percentage change in price for a one percentage point change in interest rates. In 2022, US inflation reached about 9% and long-term Treasuries lost about 30%. There is also credit risk, the chance that the issuer fails to pay. This is why company bonds usually offer higher yields than government ones. Inflation, the general rise in prices, also erodes the buying power of fixed payments.

For a private investor, bonds are the main counterweight to shares. Since 2002, a portfolio of 60% S&P 500 and 40% long Treasuries returned 8.6% a year against 11.1% for stocks alone. It was rebalanced monthly, meaning reset to those weights each month. Its worst fall was −28% against −51%. That smoother ride comes at the cost of lower long-run returns, and the protection is not constant. Correlation measures whether two assets tend to move together. The three-year correlation between US stocks and bonds was negative in 96% of months from 2000 to 2020 but positive in 94% of months from 1966 to 1999. Understanding bonds helps investors judge how much stability a portfolio really has.

By Dr. Harry Hamann

Are bonds safer than stocks?
High-quality government bonds usually swing less than stocks and repay their face value at maturity. But their prices can still fall sharply when interest rates rise. In 2022, US inflation reached about 9% and long-term Treasuries lost about 30%.

Why do bond prices fall when interest rates rise?
An existing bond pays a fixed coupon. When new bonds offer higher interest, buyers will only purchase the older, lower-paying bond at a discount. Its price falls until its return roughly matches what new bonds pay.

What is the difference between a bond and a bond fund?
A single bond has a fixed maturity date when the principal is repaid. A bond fund or ETF holds many bonds and keeps replacing maturing ones, so it has no end date and its price moves with interest rates continuously.