Bonds & Fixed Income

From Ownership to Lending

Bonds and other fixed-income investments represent a different relationship between investors and issuers than stocks. When an investor buys a bond, they are generally lending money to a government, corporation, municipality, or other organization rather than purchasing an ownership interest in it.

In return, the issuer agrees to repay the principal according to the terms of the bond and may make periodic interest payments along the way. These characteristics can make fixed income useful for generating income, managing portfolio volatility, preserving capital, and diversifying exposure beyond equities.

How Bonds Work

A bond is essentially a debt obligation. The issuer borrows capital from investors and promises to repay it according to specified terms. Those terms normally identify the amount borrowed, the maturity date, the interest structure, and other conditions that determine how the bond operates.

Investors can hold bonds until maturity or, in many cases, sell them in the secondary market before maturity. This means that a bond has both contractual characteristics established when it is issued and a market price that can change after issuance.

Principal

Principal, sometimes called face value or par value, is the amount the issuer is obligated to repay according to the bond's terms. For a conventional bond held to maturity, repayment of principal generally occurs at the maturity date, assuming the issuer meets its obligations.

Coupon

The coupon represents the interest paid by the issuer. Some bonds pay a fixed rate, while others have variable or floating rates that can change according to a specified benchmark or formula.

Not every bond makes regular coupon payments. For example, certain bonds may be issued at a discount and provide their return primarily through the difference between the purchase price and the amount received at maturity.

Maturity

Maturity is the date on which the bond becomes due according to its terms. Bonds can range from short-term securities maturing within a relatively brief period to long-term obligations extending for decades.

Maturity matters because the amount of time remaining until repayment can affect a bond's sensitivity to changes in interest rates and other market conditions.

Major Types of Bonds

The fixed-income market includes securities issued by different types of borrowers. Each category can have different credit characteristics, yields, liquidity, tax considerations, and sensitivity to economic conditions.

Government Bonds

Government bonds are issued by national governments to finance public spending and manage funding requirements. Their credit characteristics depend on the financial strength of the issuing government and the currency in which the debt is issued.

U.S. Treasury securities are a major example of sovereign debt and include Treasury bills, notes, and bonds with different maturity ranges.

Corporate Bonds

Corporations issue bonds to raise capital for operations, acquisitions, refinancing, expansion, and other business purposes. Corporate bonds expose investors to the issuer's ability to continue making interest and principal payments.

Because companies have different financial conditions and credit profiles, yields can vary substantially between corporate issuers.

Municipal Bonds

Municipal bonds are issued by states, cities, local governments, and certain public entities to finance infrastructure and other public projects. Their structures and tax treatment can vary depending on the security and the investor's jurisdiction.

High-Yield Bonds

High-yield bonds are issued by borrowers with lower credit ratings than investment-grade issuers. They generally offer higher yields to compensate investors for accepting greater credit risk.

Higher yield should not be viewed as additional return without additional risk. Changes in business conditions, financing markets, or the issuer's financial strength can have a significant effect on high-yield bond prices.

Bond Prices and Interest Rates

One of the most important concepts in fixed-income investing is the relationship between market interest rates and existing bond prices. In general, when market interest rates rise, the market value of existing fixed-rate bonds tends to fall. When rates decline, existing fixed-rate bonds may become more valuable.

The reason is relatively straightforward. If newly issued bonds offer higher interest rates, an older bond paying a lower fixed rate becomes less attractive unless its market price adjusts. Conversely, a bond paying an attractive fixed rate may become more valuable when newly issued bonds offer lower rates.

The magnitude of these price movements can differ substantially depending on the bond's maturity, coupon, yield, and other characteristics.

Understanding Bond Yield

Yield describes the return associated with a bond's income and price, but there are several ways to measure it. This is why the coupon rate and the yield shown for a bond are not necessarily the same.

Coupon Rate

The coupon rate describes the contractual interest payment relative to the bond's face value. For a traditional fixed-rate bond, this rate normally remains unchanged even if the bond's market price changes.

Current Yield

Current yield compares a bond's annual coupon payments with its current market price. Because market prices can move above or below face value, current yield can differ from the original coupon rate.

Yield to Maturity

Yield to maturity is a broader measure that considers the bond's market price, coupon payments, time remaining until maturity, and repayment of principal, based on specified assumptions. It can provide a more complete way to compare conventional bonds with different prices and maturities.

Credit Quality and Default Risk

Buying a bond creates exposure to the financial ability of the issuer to meet its obligations. Credit risk is the possibility that an issuer may fail to make scheduled interest payments, repay principal, or otherwise satisfy the terms of the debt.

Credit ratings can provide one source of information about an issuer's creditworthiness. Bonds are often broadly separated into investment-grade and below-investment-grade categories. Ratings, however, are opinions rather than guarantees and can change as financial conditions evolve.

Duration and Interest-Rate Sensitivity

Duration is an important fixed-income concept used to evaluate a bond's sensitivity to changes in interest rates. Although duration is related to maturity, the two terms are not interchangeable.

In general, bonds with higher duration tend to experience larger price movements when interest rates change. Shorter-duration bonds are typically less sensitive to the same change in rates, although they remain exposed to other forms of investment risk.

Understanding duration can therefore help explain why two bonds may react differently even when they have similar credit quality.

Key Risks in Fixed-Income Investing

Fixed income is sometimes associated with stability, but bonds are not risk-free. Different securities can expose investors to substantially different combinations of interest-rate, credit, inflation, liquidity, and reinvestment risk.

Inflation Risk

Inflation can reduce the purchasing power of future interest and principal payments. This can be particularly relevant for longer-term fixed-rate securities because their contractual cash flows may remain unchanged while the cost of goods and services rises.

Reinvestment Risk

Investors receiving interest payments or principal may need to reinvest that money at prevailing market rates. If interest rates have fallen, new investments may provide lower yields than the securities they replace.

Liquidity Risk

Not every bond trades frequently. Securities with limited market activity may be more difficult to sell quickly at a price close to their estimated value, particularly during periods of market stress.

Individual Bonds vs Bond Funds

Investors can obtain fixed-income exposure by purchasing individual bonds or through pooled vehicles such as mutual funds and exchange-traded funds. These approaches share exposure to fixed-income markets but operate differently.

An individual bond normally has a specified maturity date and contractual payment structure. A bond fund, by contrast, may continuously buy and sell securities and does not necessarily provide an investor with a single maturity date on which their original investment is returned.

Bond funds can make diversification across many issuers and maturities easier, while individual securities can provide greater control over specific maturities and cash-flow schedules. Each approach also involves its own costs and risks.

The Role of Fixed Income in a Portfolio

Fixed-income investments can serve several different purposes within a portfolio. Depending on the securities selected, they may provide recurring income, help manage overall volatility, create scheduled cash flows, or diversify exposure away from equities and other growth-oriented assets.

The appropriate mix of bonds can vary based on investment objectives, time horizon, income requirements, interest-rate expectations, liquidity needs, and tolerance for credit and market risk.

Fixed income should therefore not be treated as a single uniform asset. A short-term government security and a long-term high-yield corporate bond can have very different risk characteristics even though both are classified as bonds.

What to Consider When Comparing Bonds

Comparing fixed-income securities involves more than looking for the highest available yield. A higher yield can reflect additional credit risk, interest-rate sensitivity, liquidity constraints, or other characteristics that the market requires investors to accept.

Bonds & Fixed Income: Common Questions