What a bond is
A bond is a loan you make to a government or company. You get fixed interest and your money back at the end, provided the borrower can pay.
Learning objective: After this lesson, you can explain how a bond works and what risk remains.
With a stock you're a co-owner. With a bond you're a creditor. You lend money, get paid interest annually, and get the amount back at the end of the term.
That sounds safer, and it usually is. In bankruptcy, you're paid before shareholders. In exchange, your return is capped: if the company does brilliantly, you still only get your agreed interest.
Bonds still fluctuate, and the reason surprises many people. If general interest rates rise, your old, lower-yielding bond becomes unattractive. Nobody will pay full price for it anymore, so its price falls.
If you hold to the end, that doesn't matter, you get your amount back. If you have to sell earlier, it does. That's why a bond's term matters so much: the longer it is, the more its price swings with interest-rate changes.
A bond is a cash-flow stream made up of periodic coupons and a repayment at maturity. Its price equals the present value of that stream, discounted at the current market yield. As the market yield rises, present value falls, and the more so the further into the future the payments lie. That's the entire mechanism behind the inverse relationship between rates and price.
Sensitivity is measured through duration, defined as the present-value-weighted average time until cash flows are received. Modified duration gives an approximate percentage price change per percentage-point change in yield. A bond with a modified duration of 7 loses roughly 7 percent in price for a one-percentage-point rise in yield. Because the relationship is convex, this linear approximation slightly understates price gains and slightly overstates price losses.
Two types of risk need to be distinguished. Interest-rate risk affects the price during the term and disappears if held to maturity. Credit risk concerns the borrower's ability to pay and never disappears. The yield gap between a corporate bond and a government bond of the same maturity considered safe, the credit spread, is the market price of exactly that default risk.
| Stock | Bond | |
|---|---|---|
| Your role | co-owner | creditor |
| Return | dividends and price gains | interest, repaid at maturity |
| Upside cap | none | capped at the agreed interest |
| In bankruptcy | paid last | ahead of shareholders |
| Main risk | the company's business | solvency and rate changes |
| Volatility | high | lower, but not zero |
| Rising rates | tend to be a headwind | push down the price of existing bonds |
Summary
- As a bondholder, you're paid before shareholders, but your return is capped.
- When interest rates rise, the price of existing bonds falls.
- The longer the term, the sharper that price reaction.
- Common mistake: treating bonds as risk-free across the board — price losses, and defaults from weak issuers, are real.
Did you get it?
Why does a bond's price fall when interest rates rise?
Because new bonds offer more. The present value of the old, lower-paying cash flows drops accordingly.
What does modified duration measure?
Roughly, the percentage price change per percentage-point change in yield.
Which risk disappears if you hold to maturity, and which doesn't?
Interest-rate risk disappears; credit risk remains.
Check your understanding
Sources and further reading
- FINRA (the U.S. brokerage regulator) explains duration as a metric: for every 1 percentage-point change in interest rates, a bond's price moves roughly by its duration number in the opposite direction. View source ↗
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