How bonds work: coupons, maturity and credit risk

A bond is a loan. When you buy one, you lend money to a government, a company or another borrower, which promises to pay you interest on a schedule and return your principal on a set date. Bonds are the other big building block of financial markets alongside stocks, and they matter to stock investors too, because bond yields influence how stocks are valued.

The basic terms

• Issuer. The borrower. Common issuers are the US Treasury, federal agencies, state and local governments (municipal bonds) and corporations.
• Face value (par). The amount repaid at maturity, commonly $1,000 per bond in the US.
• Coupon. The fixed interest rate stated on the bond, applied to the face value. Many US bonds pay coupons twice a year.
• Maturity. The date the principal is repaid. Maturities run from a few weeks to 30 years or more.
• Price. Bonds trade in the market after issue, often at a price different from face value, quoted as a percentage of par.
• Yield. The return you earn given the price you pay. The link between price and yield is explained in why bond prices fall when yields rise.

How a bond pays

A bond has two cash flows: regular coupon payments and the return of face value at maturity.

Annual coupon = face value x coupon rate

A zero-coupon bond pays no coupons. It is sold at a discount to face value, and your return is the difference between the purchase price and the face value you receive at maturity.

Example (illustrative numbers)

You buy a newly issued 10-year bond with a face value of $1,000 and a 5% coupon, at par.

Annual coupon = $1,000 x 5% = $50   (paid as $25 twice a year)

Over ten years you collect $500 of coupons and then receive the $1,000 back, provided the issuer does not default. If you hold it to maturity, you know the promised cash flows in advance, which is why bonds are called fixed income. If you sell earlier, you receive the market price on that day, which may be above or below $1,000.

Types of issuers

• US Treasuries. Issued by the federal government. Treasury bills mature in a year or less, notes in 2 to 10 years and bonds in 20 or 30 years. They are generally considered to have very low credit risk because of the government's taxing power and ability to issue dollars, although their prices still move with interest rates.
• Municipal bonds. Issued by states, cities and agencies. The interest is often exempt from federal income tax, and sometimes from state tax, but rules differ.
• Corporate bonds. Issued by companies. They usually offer higher yields than Treasuries of similar maturity to compensate for greater default risk.

Credit risk and ratings

Credit risk is the chance that the issuer fails to pay interest or principal. Credit rating agencies, including S&P Global Ratings, Moody's and Fitch, grade issuers on their ability to repay.

• Investment grade. Ratings of BBB- (S&P and Fitch) or Baa3 (Moody's) and above signal a lower risk of default.
• High yield ("junk"). Ratings below those levels carry a higher chance of default, so they pay higher yields.

Ratings are opinions, not guarantees, and agencies have been wrong, sometimes badly. An issuer's debt can be downgraded, and the bond's price usually falls when that happens. In a bankruptcy, bondholders are paid before preferred and common shareholders (see common vs preferred stock).

You can get a feel for a company's ability to service debt with ratios like interest coverage.

Main risks

1. Interest rate risk. When market rates rise, existing bonds with lower coupons fall in price. Longer-maturity bonds are more sensitive.
2. Credit (default) risk. The issuer may not pay as promised.
3. Inflation risk. Fixed payments buy less if prices rise faster than expected.
4. Reinvestment risk. When a bond matures or pays coupons, rates may be lower when you reinvest.
5. Call risk. Some bonds can be redeemed early by the issuer, usually when rates have fallen, which cuts your income stream short.
6. Liquidity risk. Some bonds, particularly small municipal or corporate issues, trade rarely and can be costly to sell.

How bonds fit with stocks

Bonds usually pay a fixed return and rank ahead of stocks in a bankruptcy, so they tend to be less volatile than shares, though not risk-free, and bond prices can fall significantly when rates rise quickly. Stocks offer ownership and growth but no promised payment. Many investors hold both and decide the mix through asset allocation. The central bank's decisions on short-term rates feed through to the whole bond market (see interest rates and the Fed).

Common mistakes and limits

• Assuming bonds cannot lose money. You can lose from price drops when selling before maturity, from default or from inflation.
• Chasing the highest yield. A very high yield usually signals higher risk of loss, not a bargain.
• Confusing coupon rate with yield. The coupon is fixed on the bond; the yield depends on the price you pay.
• Ignoring maturity. A 30-year bond can swing far more than a 2-year one when rates change.
• Treating ratings as certainty. Do your own checks of the issuer's finances.

Where to see it on StocksXray

StocksXray concentrates on stocks, so individual bonds are outside its coverage. The Market Compass offers a risk gauge and an economic-regime read built from market-based signals, and the yield curve is one way the bond market itself is read for economic clues.

Key takeaways

• A bond is a loan with a coupon, a face value and a maturity date.
• Treasuries have very low credit risk; corporate and municipal bonds carry more.
• Ratings of BBB-/Baa3 and above are investment grade; below that is high yield.
• Bond prices move with interest rates, and longer bonds move more.
• Holding to maturity fixes the promised cash flows, but only if the issuer pays.

This article is educational and is not investment advice.