A bond is a way for governments and companies to borrow money from investors. When you buy a bond, you are lending money to the issuer for a set amount of time. In return, the issuer promises to pay interest and repay the original amount at maturity.
Bonds matter because they help pay for roads, schools, factories, and business expansion while giving investors a source of income.
Understanding Economics & Personal Finance: Bonds and Interest Rates
Most bonds do not stay with their first buyer until maturity. They can be sold in a secondary market, where prices change each day. A buyer compares the payments from one bond with the returns available from newly issued bonds.
This comparison helps set the market price. A bond is therefore not simply a fixed payment schedule.
It is an asset whose resale value can rise or fall before its final repayment date. An investor who sells early may receive more or less than the amount originally paid, even when the issuer makes every promised payment.
Suppose a bond pays a fixed thirty dollars each year. If new bonds begin offering larger payments for a similar amount lent, the older thirty dollar bond becomes less attractive. Its price must fall until its return is competitive.
If new market rates fall, the older payment looks better, so buyers may pay more for that bond. Longer-term bonds usually react more strongly because their fixed payments are locked in for many years.
This sensitivity is called interest rate risk. It matters most for people who may need to sell before the bond reaches maturity.
Interest rate risk is only one part of the picture. A company can face falling sales, heavy debts, or bankruptcy. A government can face weak tax income or political instability.
Credit rating agencies estimate the chance of missed payments, but ratings are informed opinions rather than promises. Inflation creates a separate problem. A payment that seems useful today may buy less in ten years.
Liquidity matters too. A widely traded bond is easier to sell at a fair price than a rarely traded one.
Some bonds can be called, meaning the issuer can repay early under stated rules. That can limit an investor's gains when rates fall.
When studying a bond, separate its coupon from its market yield. The coupon is set when the bond is issued, while the yield changes with the trading price. Note the maturity date, issuer, credit rating, call terms, and whether payments are taxable.
Many people own bonds through pension funds or bond mutual funds rather than as individual certificates. A fund spreads money across many issuers, but its share price can still fall when rates rise. Reading a simple bond quote helps students connect news about central bank rates with choices made by households, businesses, and public agencies.
Key Facts
- Bond price and market interest rates usually move in opposite directions.
- Annual coupon payment = face value × coupon rate.
- Current yield = annual coupon payment ÷ current bond price.
- A bond with a 50 per year.
- Maturity is the date when the issuer repays the bond's face value.
- Higher default risk usually means investors demand a higher interest rate.
Vocabulary
- Bond
- A bond is a loan an investor makes to a government or company in exchange for interest payments and repayment later.
- Issuer
- The issuer is the government, city, or company that borrows money by selling a bond.
- Coupon rate
- The coupon rate is the stated annual interest rate paid on the bond's face value.
- Face value
- Face value is the amount the issuer promises to repay when the bond matures.
- Yield
- Yield is the return an investor earns on a bond based on its payments and price.
Common Mistakes to Avoid
- Thinking a bond is the same as a stock is wrong because a bond is debt while a stock is ownership in a company.
- Ignoring interest rate changes is wrong because rising market rates can lower the price of existing bonds.
- Assuming all bonds are risk-free is wrong because companies and governments can have different chances of missing payments.
- Confusing coupon rate with yield is wrong because the coupon rate is based on face value, while yield depends on the price you actually pay.
Practice Questions
- 1 A company sells a bond with a $1,000 face value and a 6% coupon rate. How much interest does the bond pay each year?
- 2 A bond pays 800. What is its current yield?
- 3 A student owns a bond paying 4% interest. New bonds of similar risk start paying 6%. Explain what will likely happen to the price of the student's bond and why.