This cheat sheet covers the main ideas students need to understand bonds and fixed income investments. Bonds are loans made to governments, companies, or other issuers in exchange for interest payments and repayment of principal. Students need this reference to compare bonds, understand why prices change, and connect investment risk to potential return.
It is especially useful for personal finance, investing, and economics units.
The most important ideas are face value, coupon payments, bond price, yield, maturity, duration, and credit risk. A basic annual coupon is found with coupon payment = face value × coupon rate. Current yield is found with current yield = annual coupon payment ÷ current bond price.
Bond prices and market interest rates usually move in opposite directions, which is one of the key rules of fixed income investing.
Key Facts
- A bond is a loan to an issuer, and the investor receives interest payments plus repayment of face value at maturity if the issuer does not default.
- Annual coupon payment = face value × coupon rate.
- Current yield = annual coupon payment ÷ current bond price.
- If market interest rates rise, existing bond prices usually fall because their fixed payments become less attractive.
- If market interest rates fall, existing bond prices usually rise because their fixed payments become more attractive.
- Yield to maturity is the estimated annual return if the bond is held until maturity and all promised payments are made.
- Longer maturity and higher duration usually mean greater price sensitivity to interest rate changes.
- Higher credit risk usually requires a higher yield to compensate investors for the chance of default.
Vocabulary
- Bond
- A bond is a debt investment where an investor lends money to an issuer in exchange for interest payments and repayment later.
- Face Value
- Face value is the amount the bond issuer promises to repay when the bond reaches maturity.
- Coupon Rate
- The coupon rate is the annual interest rate paid on the bond's face value.
- Yield
- Yield is the return an investor earns from a bond compared with the price paid for it.
- Maturity
- Maturity is the date when the bond issuer must repay the bond's face value.
- Duration
- Duration is a measure of how sensitive a bond's price is to changes in interest rates.
Common Mistakes to Avoid
- Confusing coupon rate with yield is wrong because the coupon rate is based on face value, while yield depends on the price paid for the bond.
- Assuming bonds cannot lose value is wrong because bond prices can fall when interest rates rise or when the issuer becomes riskier.
- Ignoring maturity is wrong because longer-term bonds usually have more interest rate risk than shorter-term bonds.
- Comparing bonds only by coupon payment is wrong because a high coupon may still be a poor deal if the bond price is high or default risk is large.
- Forgetting default risk is wrong because some issuers may fail to make interest payments or repay principal.
Practice Questions
- 1 A bond has a face value of $1,000 and a coupon rate of 5%. What is its annual coupon payment?
- 2 A bond pays 1,200. What is its current yield?
- 3 A 950. Is its current yield greater than, less than, or equal to 4%?
- 4 Explain why the price of an existing bond usually falls when new bonds are issued with higher interest rates.
Understanding Bonds & Fixed Income Reference
A bond’s cash flows happen at different times, so investors compare them in today’s money. This is called present value. Money received next year is worth a little less than money received today because today’s money could earn interest elsewhere.
Each future coupon payment and the final repayment are discounted using a market rate. Adding those discounted amounts gives an estimate of a fair bond price. This explains the price and interest rate connection at a deeper level.
When the required market rate rises, future payments are discounted more heavily. Their value today becomes smaller.
The coupon rate is set when a bond is issued, but the yield seen by a new buyer can change every day. A bond bought below its face value has an extra source of return because its value moves upward toward face value as maturity approaches, assuming the issuer remains able to pay. A bond bought above face value has the opposite effect.
Its final repayment is lower than the purchase price. Yield to maturity includes coupon income plus this gain or loss spread over the remaining years.
It is an estimate, not a guarantee. It assumes the bond is kept until maturity and that coupon payments can be reinvested at the same rate.
Duration gives a more useful picture than maturity alone. Maturity tells when the final repayment is due. Duration considers the timing of every payment, so earlier coupon payments reduce duration.
A bond with no regular coupons, often called a zero coupon bond, has duration close to its maturity because all its cash arrives at the end. Higher duration means a larger price movement when rates change.
For a rough estimate, a duration of five years suggests that a one percentage point rise in interest rates could lead to about a five percent fall in price. The actual change can differ because the relationship is curved rather than perfectly straight.
Credit ratings are opinions about an issuer’s ability to make payments. They help investors compare risk, but they are not promises. A government can have different risks from a company, and companies can weaken quickly during a recession or after taking on too much debt.
Some bonds can be hard to sell before maturity, especially bonds from smaller issuers. This is liquidity risk. Inflation is another concern because fixed payments may buy less over time.
Students may meet bonds through savings products, retirement funds, bond mutual funds, or news about central bank rate decisions. When comparing choices, check the issuer, payment schedule, maturity date, yield measure, fees, inflation risk, and whether the investment can be sold easily.