Bond: Definition, How It Works & Types
How Bonds Work
Think of a bond as an IOU with a schedule. When you buy a bond, you’re lending money. In return, the issuer promises two things: periodic interest payments (called coupons) and the return of your original investment at maturity.
Here’s the basic lifecycle. An issuer — say the U.S. Treasury or a company like Apple — needs capital. Instead of taking a bank loan, it issues bonds to the public market. You buy one at its par value (usually $1,000). Every six months, you receive a coupon payment. When the bond matures, you get your $1,000 back.
The critical relationship to understand: bond prices and interest rates move in opposite directions. When rates rise, existing bond prices fall — because new bonds offer higher coupons, making older ones less attractive. When rates drop, existing bonds become more valuable. This inverse relationship is the single most important concept in fixed income.
Key Bond Terms
| Term | What It Means |
|---|---|
| Face Value / Par Value | The amount the issuer repays at maturity — typically $1,000 per bond |
| Coupon Rate | The annual interest rate paid on the face value |
| Maturity Date | When the issuer must return the face value to the bondholder |
| Yield to Maturity (YTM) | Total return if you hold the bond until it matures, accounting for price, coupon, and time |
| Current Yield | Annual coupon divided by the bond’s current market price |
| Credit Rating | A grade (e.g., AAA, BBB) reflecting the issuer’s ability to repay — assigned by agencies like Moody’s and S&P |
| Duration | A measure of how sensitive a bond’s price is to interest rate changes |
Bond Pricing — Premium, Discount, and Par
Bonds rarely trade at exactly par value in the secondary market. The market price fluctuates based on interest rates, credit quality, and time to maturity.
| Scenario | Market Price vs. Face Value | Why It Happens |
|---|---|---|
| At Par | Price = $1,000 | Coupon rate matches prevailing market rates |
| At a Premium | Price > $1,000 | Coupon rate is higher than current market rates — investors pay extra for the better income |
| At a Discount | Price < $1,000 | Coupon rate is lower than current market rates — the bond must be cheaper to attract buyers |
Types of Bonds
Bonds are categorized by who issues them, how they pay, and the risk they carry. Here are the main types you’ll encounter:
By Issuer
| Type | Issuer | Key Characteristics |
|---|---|---|
| Treasury Bonds | U.S. federal government | Considered risk-free; 20–30 year maturities; exempt from state/local taxes |
| Treasury Notes | U.S. federal government | 2–10 year maturities; benchmark for many interest rates |
| Treasury Bills | U.S. federal government | Under 1 year; sold at a discount, no coupon payments |
| Municipal Bonds | State and local governments | Interest often exempt from federal income tax (and sometimes state tax) |
| Corporate Bonds | Corporations | Higher yields than Treasuries; risk depends on issuer’s credit rating |
By Structure
| Type | How It Works |
|---|---|
| Zero-Coupon Bonds | No periodic interest — sold at a deep discount to face value and redeemed at par |
| Callable Bonds | Issuer can redeem early before maturity, usually when rates fall |
| Convertible Bonds | Bondholder can convert the bond into a set number of the issuer’s shares |
By Credit Quality
Bonds rated BBB– or higher by S&P (Baa3 by Moody’s) are classified as investment grade. Anything below that is considered high-yield (junk). The lower the credit quality, the higher the credit spread — the extra yield investors demand for taking on more default risk.
Example: Reading a Bond
Suppose you see a bond described as: Apple 3.75% 2028. Here’s what that tells you:
Coupon Rate: 3.75% annually on the face value
Maturity: 2028
Face Value: $1,000 (standard)
Annual Coupon Payment: $37.50 (3.75% × $1,000), typically paid as $18.75 every six months
If the bond is currently trading at $980, it’s at a discount. Your current yield would be $37.50 ÷ $980 = 3.83%, slightly higher than the 3.75% coupon rate. Your yield to maturity would be even higher because you’d also gain $20 when the bond matures at par.
Risks of Investing in Bonds
Interest rate risk is the big one. If you need to sell before maturity and rates have risen, your bond is worth less than what you paid. Duration quantifies exactly how much price risk you’re taking — longer duration means more sensitivity to rate changes.
Credit risk is the chance the issuer defaults. A Treasury bond has essentially zero credit risk. A junk bond from a struggling company has meaningful default risk, which is why it pays a higher yield.
Inflation risk erodes the purchasing power of your fixed coupon payments. If inflation runs at 5% and your bond pays 3%, you’re losing real value every year.
Call risk applies to callable bonds. If rates drop significantly, the issuer can retire the bond early and refinance at a lower rate — leaving you to reinvest at worse terms.
Where Bonds Fit in a Portfolio
Bonds serve as a stabilizer. They tend to be less volatile than stocks and often move in the opposite direction during market stress — though this relationship isn’t guaranteed. In a traditional asset allocation, bonds reduce overall portfolio volatility and provide predictable income. The classic 60/40 portfolio allocates 60% to equities and 40% to bonds, although many investors adjust that ratio based on age, goals, and the rate environment.
For a deeper look at how bonds function as an asset class, see our guide on How Bonds Work. For a comparison with equities, check out Stocks vs. Bonds.
Key Takeaways
- A bond is a loan from an investor to a borrower, with scheduled interest payments and a return of principal at maturity.
- Bond prices and interest rates move inversely — when rates rise, bond prices fall, and vice versa.
- The main types include Treasuries (lowest risk), municipal bonds (tax advantages), and corporate bonds (higher yield).
- Key metrics to know: coupon rate, current yield, yield to maturity, duration, and credit rating.
- Bonds carry interest rate risk, credit risk, inflation risk, and (sometimes) call risk.
Frequently Asked Questions
What is the difference between a bond and a stock?
A stock represents ownership in a company. A bond represents a loan to a company or government. Bondholders are creditors — they get paid before stockholders if the issuer goes bankrupt. However, bonds have limited upside (you get your principal back plus interest), while stocks have unlimited upside potential. See Stocks vs. Bonds for a detailed comparison.
Are bonds a safe investment?
It depends on the bond. U.S. Treasury bonds are among the safest investments in the world because they’re backed by the federal government. Corporate bonds from blue-chip companies are relatively safe but carry some credit risk. Junk bonds carry meaningful default risk. No bond is completely risk-free — even Treasuries carry inflation and interest rate risk.
How do I buy bonds?
You can buy U.S. Treasuries directly from the government through TreasuryDirect.gov. Corporate and municipal bonds can be purchased through a brokerage account. Many investors get bond exposure through bond ETFs or mutual funds, which offer diversification and liquidity without needing to pick individual bonds.
What happens when a bond matures?
The issuer pays you the full face value (typically $1,000 per bond). Your coupon payments stop. If you bought the bond at a discount, the difference between your purchase price and face value adds to your total return. If you bought at a premium, that difference reduces it.
What is a bond’s yield?
Yield measures the return you earn from a bond. Current yield is simply the annual coupon divided by the current price. Yield to maturity (YTM) is the more complete measure — it accounts for the coupon, the price you paid, and the time remaining until maturity. YTM is the standard metric used to compare bonds.