Bonds: How Rates and Prices Move Together
Coupon, maturity, yield, ratings and duration – how bonds work, why their prices fall when rates rise, and what risks hide in supposedly safe paper.
Key takeaways
- A bond is a tradable loan. You lend money to a government or company and receive interest (the coupon) plus your principal back at maturity.
- Prices and yields move in opposite directions. When market rates rise, existing bond prices fall – and vice versa.
- How strongly a bond reacts to rate changes is measured by its duration. Long maturities mean big interest rate risk.
- A credit rating describes default risk. Weaker borrowers pay higher interest.
- What matters is the yield to maturity, not the coupon alone.
Stocks get the headlines, but the bond market is bigger. Governments fund their budgets with bonds, companies their factories, banks their lending. For investors, bonds are the classic counterweight to stocks: lower returns, lower swings – most of the time. The year 2022 showed just how relative “safe” can be.
A loan you can trade
A bond is a loan packaged as a security. The issuer borrows from many investors at once and promises:
- regular interest payments, the coupon – say 3% a year,
- and repayment of the face value (par) at the end, on the maturity date.
Bond prices are quoted as a percentage of face value. A price of 100 means “at par”; a price of 95 means you pay $950 for a bond that repays $1,000 at maturity.
| Feature | Example |
|---|---|
| Issuer | US Treasury |
| Face value | $1,000 |
| Coupon | 3.0% a year ($30, paid semi-annually) |
| Maturity | 10 years |
| Price today | 97.50 |
Unlike a shareholder, a bondholder isn’t an owner but a lender. You don’t get more when the business booms – but you are paid before shareholders when things go wrong.
Coupon isn’t yield
The coupon is fixed. The price isn’t. That’s why the return you actually earn almost always differs from the coupon.
The key number is the yield to maturity (YTM). It answers: what annual return do I earn if I buy at today’s price, collect all coupons and hold to the end?
The golden rule: rates up, prices down
Suppose you bought a bond for $1,000 with a 2% coupon. Then market rates rise and new bonds from the same issuer pay 4%. Who would pay you $1,000 for your 2% bond when the same money buys 4%? Nobody. Your bond is only worth as much as gives a buyer roughly 4% overall – its price falls.
The reverse is also true: when rates fall, your higher-coupon bond becomes more desirable and its price rises.
Play with the calculator: set the market yield above the coupon and the price drops below 100. Increase the maturity and the curve gets steeper – the bond reacts more strongly.
Duration: how sensitive is my bond?
How strongly a price reacts to rate changes is measured by duration. Modified duration tells you roughly how many percent the price falls when the yield rises one percentage point.
- A bond with a duration of 2 loses about 2% if yields rise by one point.
- A bond with a duration of 20 loses about 20%.
Duration is higher the longer the maturity and the lower the coupon. With long bonds, most of the money arrives far in the future – and those distant payments lose the most value when rates rise.
Credit risk: will the borrower pay?
The second big risk is default. A company can go bankrupt, a government can fail to service its debt. Agencies like S&P, Moody’s and Fitch assess issuers with credit ratings:
The lower the rating, the higher the interest an issuer must pay. The difference to a safe government bond’s yield is the credit spread. In crises, spreads widen as investors demand more compensation.
The main types of bonds
| Type | Issuer | Typical features |
|---|---|---|
| Government bonds | US Treasury, Germany, UK | Highly liquid, the safest asset in their currency |
| Municipal bonds | US states and cities | Interest often exempt from federal tax |
| Corporate bonds | Apple, Ford, utilities | Higher yields, default risk depends on rating |
| Inflation-linked bonds | TIPS, linkers | Principal rises with inflation, protects purchasing power |
| Zero-coupon bonds | various | No coupon, bought well below par |
Why own bonds?
Bonds do three main jobs in a portfolio:
- Stability: High-quality bonds swing far less than stocks.
- Balance: In many stock market crises – 2008, March 2020 – Treasuries rose while stocks fell. That isn’t guaranteed: in 2022 both fell together, because the shock was rising interest rates.
- Predictable income: If you hold a bond to maturity, you know your return in advance – provided the issuer pays.
For most investors the simplest route is a bond ETF holding hundreds of bonds. Keep in mind: a fund never matures. It behaves like a bond with a roughly constant duration and fluctuates accordingly. If you want to avoid rate risk, choose short maturities, Treasury bills or money market funds.
Summary
Bonds are tradable loans with a fixed coupon and repayment at par. Their prices move opposite to market rates, and the longer the maturity, the stronger the move. Ratings describe default risk; the credit spread is its price. Used well, bonds steady a portfolio – but they are not blindly “safe”.
Next: the building block most investors use today – funds and ETFs.
Time to practise
13 short exercises on this lesson – mistakes come back at the end. Then the lesson is complete and joins your review queue.
Test your knowledge
0/401You hold a bond with a 2% coupon. Comparable new bonds suddenly pay 4%. What happens to your bond’s price?
02Which bond loses most if yields rise by one percentage point?
03A bond trades at 90, matures in one year and pays a 2% coupon. Roughly what return do you earn if you hold it to maturity and the issuer pays?
04What does a “BB” rating mean?