Bond

How bonds work

Governments, companies, municipalities, and other entities issue bonds to finance spending, investment, acquisitions, or refinancing. Terms normally specify principal, maturity, coupon, payment dates, currency, seniority, and covenants. Investors may hold a bond until maturity or trade it beforehand. Market value changes as yields, credit quality, liquidity, and embedded options change.

Sources of return

Bond return can come from coupon income, reinvestment of coupons, repayment of principal, and a price gain or loss. Yield to maturity summarizes the contractual cash flows and current price under restrictive assumptions. Realized return differs when the bond is sold early, defaults, is called, coupons are reinvested at another rate, or currency moves.

Example

An investor buys a $1,000 face-value five-year bond with a 4% annual coupon. The issuer pays $40 each year and repays $1,000 at maturity if it performs as promised. If comparable yields later rise, the bond's market price generally falls because its fixed payments are less attractive, even though its coupon remains unchanged.

How to interpret a bond

Review yield together with credit, duration, seniority, call features, currency, liquidity, and tax treatment. A higher yield usually signals some combination of greater credit risk, rate sensitivity, illiquidity, optionality, or market dislocation. Distinguish an individual bond with a maturity date from a bond fund that continually replaces holdings and has no single principal-repayment date.

Risks and limitations

Bonds face interest-rate, credit, inflation, liquidity, reinvestment, currency, and call risk. Government backing and legal remedies vary by issuer and jurisdiction. Holding to maturity limits sensitivity to interim price changes only if the investor can hold, the issuer pays, and no option changes the schedule. Inflation can still reduce the purchasing power of all payments.

Practical checklist

Read the prospectus or offering document, identify the legal issuer and claim priority, map every cash flow, and check call, put, conversion, and covenant terms. Compare yield with a maturity-matched reference curve and estimated transaction cost. Model default, recovery, rate, spread, and currency scenarios. Confirm that expected liquidity and payment dates fit the portfolio's obligations and mandate.

Sources and further reading

• Bonds: Frequently Asked Questions, Investor.gov, U.S. Securities and Exchange Commission