Bond in plain English
A bond is a debt security. The issuer borrows money from investors and promises payments under a legal contract. Investor.gov describes a bond as an IOU: the issuer generally pays a specified rate of interest during the bond's life and repays principal at maturity.
That short description covers many structures. Interest can be fixed, floating, inflation linked, contingent, or zero until maturity. A bond can be callable by the issuer, convertible into stock, secured by assets, subordinated to other debt, or supported only by the issuer's general credit. Read the prospectus, official statement, or offering document for the exact security.
“Fixed income” does not mean fixed market value or guaranteed return. Bond prices can fall, an issuer can default, and reinvested cash flows may earn less than expected.
Core bond terms
- Face value or par value: the principal amount used for contractual calculations and normally due at maturity, subject to the terms and credit outcome.
- Coupon rate: the annual interest rate stated as a percentage of par for a traditional fixed-rate bond.
- Coupon payment: the dollars paid on each scheduled date. A 6% coupon on $1,000 par pays $60 annually, perhaps as two $30 payments.
- Maturity: the date principal is scheduled to be repaid.
- Market price: what buyers and sellers currently agree to pay, often quoted as a percentage of par.
- Yield: a return measure that relates cash flows to price under stated assumptions.
- Issuer: the government, municipality, corporation, agency, or other entity obligated under the security.
A quote of 98.50 commonly means $985 per $1,000 par, before accrued interest and transaction charges. Confirm the quote convention because products and venues differ.
Price and yield move in opposite directions
For a conventional fixed-rate bond, price and yield move inversely. Suppose newly issued comparable bonds yield 6% while an existing bond pays a 4% coupon. Investors generally will not pay full par for the lower coupon if credit and terms are otherwise similar, so its price falls until its yield becomes competitive.
If market yields fall below 4%, the existing coupon becomes more attractive and the bond can trade above par. At maturity, a nondefaulted bond's price converges toward the contractual redemption amount, subject to final cash flows and terms.
This relationship does not mean every bond price changes by the same amount. Time to maturity, coupon, cash-flow timing, embedded options, and credit spreads determine sensitivity. Duration estimates price sensitivity to a yield change under assumptions; convexity refines the estimate for larger moves. They are risk measures, not promises.
Coupon rate, current yield, and yield to maturity
The coupon rate uses par value. Current yield divides annual coupon dollars by the current market price. A bond paying $50 annually and priced at $900 has a current yield of about 5.56%, even though its coupon rate is 5% on $1,000 par.
Yield to maturity (YTM) estimates the annualized return if the bond is held to maturity, all scheduled payments occur, and interim cash flows are reinvested at the assumed rate. It accounts for coupon payments and the difference between price and redemption value. Those assumptions may not occur.
For a callable bond, yield to call and yield to worst can be more informative because the issuer may redeem it before maturity. Compare yields calculated on the same basis, settlement date, compounding convention, and credit assumptions. A high displayed yield often signals risk rather than a bargain.
Major types of bonds
U.S. Treasury marketable securities are backed by the U.S. government's payment obligation and include bills, notes, bonds, TIPS, and floating-rate notes. They differ in maturity and cash-flow design.
Municipal bonds are issued by states, cities, and related entities. Some interest may receive favorable federal or state tax treatment, but rules and investor circumstances differ. General-obligation and revenue bonds rely on different payment sources.
Corporate bonds depend on a company's credit and can range from investment grade to high yield. Agency and government-sponsored-enterprise debt can have different legal relationships to the federal government; do not assume every agency-named security has the same guarantee as a Treasury.
Mortgage-backed and asset-backed securities pass through cash flows from pools of loans or receivables. Borrower prepayments and defaults can change timing. International bonds add currency, jurisdiction, and sovereign risks.
The issuer label is only a starting point. Security-level terms and seniority govern the claim.
Credit risk and seniority
Credit risk is the possibility that the issuer fails to make promised payments or restructures the debt. Credit ratings express an agency's opinion under its methodology, not a guarantee. Ratings can be wrong or downgraded after price losses occur.
Review leverage, cash flow, liquidity, debt maturities, covenants, collateral, seniority, and the source of repayment. Senior secured bonds generally claim specified collateral ahead of unsecured or subordinated debt, but recovery depends on asset value, legal process, and competing claims.
Credit spreads—the extra yield over a reference rate—can widen when perceived risk rises, reducing price even if benchmark Treasury yields are unchanged. A bond can therefore lose value from interest-rate and credit-spread moves at the same time.
Call, reinvestment, inflation, and liquidity risk
A call provision lets the issuer redeem a bond under stated conditions. Issuers often call higher-coupon debt when refinancing is favorable, leaving investors to reinvest sooner at lower yields. The investor keeps downside from rising rates but may have upside capped when rates fall.
Reinvestment risk arises because coupon payments or returned principal may earn less than the YTM assumption. Inflation risk erodes the purchasing power of fixed nominal payments. Liquidity risk appears when a bond is hard to sell near an estimated fair value; dealer markups, markdowns, and bid-ask spreads can materially affect small trades.
Some bonds have sinking funds, make-whole calls, put rights, floating coupons, payment-in-kind features, or conversions. Generic calculators may mishandle them.
Buying and selling individual bonds
New bonds are distributed in the primary market under offering documents. Outstanding bonds trade over the counter through dealers and platforms rather than in one centralized stock-style order book. Quotes can be indicative, inventory dependent, and size sensitive.
For U.S. corporate, agency, and municipal bonds, FINRA's bond resources and TRACE data can help investors review transaction information, subject to coverage and reporting rules. Compare the exact CUSIP, quantity, time, price, yield, and any markup or commission.
Between coupon dates, a buyer commonly pays the seller accrued interest in addition to the quoted clean price. The buyer later receives the full coupon, so accrued interest allocates the period economically. Settlement statements distinguish clean price, accrued interest, and total consideration.
Selling before maturity exposes the holder to the market price then available. “Holding to maturity” avoids realizing an interim quote only if the issuer pays as promised, the security is not called, and the investor does not need the money earlier.
Individual bonds versus bond funds
An individual conventional bond has a stated maturity and contractual cash flows, subject to default and embedded options. A bond mutual fund or ETF owns a changing portfolio and ordinarily has no single maturity date at which an investor's original principal is promised back.
Funds provide diversification, professional administration, reinvestment, and easier trading, but their net asset values fluctuate. Expenses, turnover, flows, tracking, premiums or discounts, and portfolio changes affect results. A target-maturity fund is still a fund with specific liquidation and reinvestment terms, not identical to one bond.
Compare average duration, credit quality, sector exposure, yield definition, distributions, expenses, holdings, and historical drawdowns. A distribution yield is not the same as YTM and can include return of capital in some products.
Tax considerations
Bond interest, original issue discount, market discount, premiums, sales, and tax-exempt claims can receive different U.S. tax treatment. Treasury interest is generally subject to federal income tax but exempt from state and local income taxes; municipal treatment depends on issuer, residence, use of proceeds, and other rules.
Taxable-equivalent yield can help compare tax-exempt and taxable bonds, but it requires the investor's actual marginal rates and consideration of alternative-minimum-tax or state rules. Use current IRS guidance and professional advice for material decisions.
Common bond mistakes
- Calling fixed income risk free. Market, credit, inflation, liquidity, and call risks remain.
- Confusing coupon with yield. Price and redemption affect investor return.
- Chasing the highest yield. Extra yield can compensate for default, extension, call, or liquidity risk.
- Assuming a rating is a guarantee. It is an opinion that can change.
- Ignoring duration. Long cash flows can be highly rate sensitive.
- Assuming every government-related issuer has Treasury backing. Legal guarantees differ.
- Forgetting accrued interest and dealer compensation. Total cost can exceed the clean quote.
- Calling a bond fund an individual bond. A fund lacks one contractual maturity for the shareholder.
- Relying on YTM assumptions as certainty. Defaults, calls, sales, and reinvestment can change results.
- Ignoring taxes and inflation. Nominal yield is not usable real return.
A practical bond checklist
Identify the issuer, CUSIP, face amount, coupon, maturity, payment dates, seniority, collateral, covenants, call or put schedule, and redemption terms. Read the official offering document and recent financial disclosures. Check price, yield-to-maturity, yield-to-call, yield-to-worst, duration, credit spread, rating history, and recent comparable trades.
Then test default, rate, inflation, liquidity, and reinvestment scenarios. Calculate total purchase cost, taxes, and the role of the bond in the wider portfolio. A bond is a contract, and the quality of the decision depends on reading the contract rather than relying on the word “income.”