Concepts in this lesson
- Coupon
- The fixed yearly interest a bond pays, as a percentage of its face value, usually in two payments a year.
- Yield to maturity
- The yearly return from buying a bond at today's price and holding it to maturity, counting every coupon.
- Duration
- Roughly the percent a bond's price moves the opposite way per 1 percentage point change in yield.
- Credit rating
- A rating agency's grade of a borrower's ability to repay; BBB− and above is investment grade, below it high yield.
01The IOU
A city wants to build a bridge and needs $50 million now. It doesn't have it, so it borrows: it sells IOUs, each promising to pay the holder $40 a year in interest for ten years and then repay $1,000. You buy one for $1,000. That IOU is a bond.
Every bond has the same three terms:
- Face value (or par): the amount repaid at the end, usually $1,000 a bond.
- Coupon: the fixed interest, as a percentage of face value. A 4% coupon pays $40 a year, usually in two payments of $20.
- Maturity: the date the face value is repaid and the bond ends.
Unlike a stock, a bond's cash flows are set in advance. If the borrower keeps its promise, you know exactly what you will receive and when.
02How a bondholder gets paid
- Coupons, twice a year, until maturity.
- The face value, at maturity.
- Price changes, if you sell before maturity. A bond bought below face value also drifts up toward it as maturity nears, and one bought above drifts down.
The single number that sums all of this up is the yield to maturity: the yearly return you earn if you buy at today's price, hold to the end and every payment arrives. When people say "the 10-year yield is 4%", that is the number they mean.
03The seesaw: price and yield
You hold that 4% bond. A year later new bonds of the same kind pay 5%. Nobody will pay you $1,000 for a bond paying $40 when $1,000 buys a new one paying $50. To sell yours, you have to cut the price until a buyer earns 5% on it too. That's why bond prices and yields always move in opposite directions.
| Market yield | Price | Change |
|---|---|---|
| 3% | $1,085.84 | +8.6% |
| 4% | $1,000.00 | — |
| 5% | $922.05 | −7.8% |
| 6% | $851.23 | −14.9% |
When the yield equals the coupon, the bond trades at face value. Below the coupon, at a premium; above it, at a discount.
04Duration: how hard the seesaw swings
Not every bond swings the same amount. A bond maturing in two years barely moves: you'll have your $1,000 back soon and can reinvest it at the new rate. A 30-year bond swings hard: you're locked into the old coupon for decades. At a 5% market yield, our 4% coupon is worth $981.19 as a 2-year bond but $845.46 as a 30-year one.
Duration puts a number on it: roughly, the percent a bond's price moves for each 1-point change in yields, the opposite way.
The 10-year 4% bond at a 4% yield has a duration of 8.18. If yields rise one point, duration predicts a fall of about 8.2%. The real fall is 7.8%, to $922.05: the rule slightly overstates losses and understates gains, because the price curve bends (the curve's bend is called convexity).
Lock in a long bond and you've made a fixed bet on rates: if they fall, your bond is suddenly worth a lot more to anyone who wants to buy it; if they rise, you're stuck with a stake that pays less than the new game. Short bonds are small, quick hands: less to win or lose on each, and you're back in the next deal soon.
05Who you lend to
The coupon also depends on who's borrowing. The US government can tax and print its own currency, so its bonds are treated as the benchmark for safety. A struggling company must pay much more to persuade anyone to lend. The extra yield over a government bond of the same maturity is the credit spread, the market's price for the chance of not being repaid. A bond paying 9% when governments pay 4% is paying the extra for a reason.
If a company does fail, its bondholders are paid before its shareholders, which is why a company's bonds are safer than its stock. Safer is not the same as safe: they may get back only part of what they lent.
Rating agencies grade borrowers. Bonds rated BBB− (Baa3 at Moody's) or better are investment grade; below that they are high yield, also called junk. See the credit rating entry for the full scale.
06The main kinds
- Government bonds. US Treasuries (bills up to a year, notes 2 to 10 years, bonds 20 and 30) and Government of Canada bonds. Our Bonds & cash reports cover them maturity by maturity.
- Inflation-linked bonds. TIPS in the US adjust their principal with consumer prices, up with inflation and down with deflation, so their coupons are paid on that adjusted amount.
- Corporate bonds. Loans to companies, at a spread over government yields that matches their credit.
- Municipal bonds. Loans to US states and cities, with interest that is often free of federal income tax.
07What can go wrong
- Rates rise. Prices fall, and the longer the bond, the further. Holding to maturity doesn't make the loss disappear: you take it either now, by selling, or slowly, by collecting a 4% coupon for years while new bonds pay 5%. And a bond fund never matures, so there is no date on which its fall reverses by itself.
- Inflation. A fixed coupon buys less every year that prices rise.
- Default. The borrower misses payments; bondholders may recover only part of their money.
- Call risk. Many corporate bonds can be repaid early when rates fall, just when you would like to keep them.