A bond is a tradable IOU. You lend money to a government, company or other issuer, and in exchange you usually receive regular interest payments, then your principal back on a set date called maturity.
Unlike shares, which represent ownership, bonds are debt. They sit in the fixed income part of the market and are generally quoted as a percentage of their face value, also called par.
What does a bond pay and when?
Most bonds pay a fixed coupon, stated as an annual rate on the face value. A 4 per cent coupon on a 100 face value means 4 in interest each year, paid in one or two instalments depending on the market. Some bonds have no periodic interest at all. These zero coupon bonds are issued at a discount and repay 100 at maturity.
Key features appear on the term sheet when a bond is issued:
- Face value (par): The principal that is due back at maturity, often 100 or 1,000 in the bond’s currency.
- Coupon rate and frequency: Fixed, floating or zero, paid annually, semi-annually or on another schedule.
- Maturity date: When principal is scheduled to be repaid. Bonds can be short, medium or long dated.
- Seniority and security: Where the bond ranks in a default and whether assets are pledged as collateral.
- Currency and law: The denomination and the legal jurisdiction governing the contract.
Between coupon dates, interest accrues to the seller. Market quotes often show a clean price that excludes accrued interest. The amount you pay to settle the trade, called the dirty price, is the clean price plus the accrued coupon. Day-count and settlement conventions vary by market.
Price, yield and why they move in opposite directions
Bond investors talk in yields because the coupon alone does not tell you the return. If a bond trades below par, the combination of coupon income and the pull back to 100 at maturity boosts the yield. If it trades above par, that pull works against you.
There are two common yield measures:
- Current yield: Annual coupon divided by the market price. It ignores maturity and redemption.
- Yield to maturity (YTM): The annualised return if you hold to maturity and receive all payments on time. It rolls together price, coupons and redemption.
Prices fall when market yields rise, and rise when yields fall. That inverse relationship is core to fixed income. Small moves in yield are often quoted in the unit called a basis point, which is one hundredth of a per cent.
The sensitivity of a bond’s price to yield changes is captured by duration. Longer maturities and lower coupons generally mean higher duration, so bigger price swings for a given move in yields. Very large moves are shaped by convexity, which reflects the curve in the price-yield relationship.
Common types of bonds you will see
- Government bonds: Issued by national governments. Often viewed as lower credit risk in their own currency. Examples include gilts and Treasuries.
- Investment grade corporates: Issued by companies with stronger credit ratings. Typically pay more than government bonds to compensate for extra risk.
- High yield (sub-investment grade): Higher coupons to compensate for greater default risk. Prices can be more volatile.
- Inflation-linked: Coupons and/or principal move with an inflation index to help protect real value.
- Floating-rate notes: Coupons reset to a reference rate plus a margin, which reduces interest rate risk but introduces reference rate exposure.
- Callable or puttable: The issuer may redeem early at a set price, or investors may have the right to sell back. Options embedded in a bond affect its yield and price behaviour.
- Convertible bonds: Can be converted into shares on stated terms, so their value is linked to both credit and equity performance.
- Supranational and municipal: Issued by development banks, agencies or local authorities with varying tax and credit features.
How bonds are issued and traded
New bonds are sold in the primary market. Governments often sell in an auction where a single clearing yield sets the price for a batch of securities. Companies typically issue via a bookbuild run by banks, which place bonds with investors at an agreed spread over a benchmark.
After issue, most activity happens in the dealer-led over-the-counter market rather than on a central exchange. Quotes are shown as a price or a yield, and trading sizes vary widely from retail-friendly minimums to large institutional blocks. The exact order types, settlement times and minimum denominations vary by provider and venue. For an overview of how prices are quoted and positions are managed after issue, see our page on bond trading.
Market participants often compare yields across maturities on a yield curve. The curve reflects expectations for policy rates, inflation and term premia, and it anchors how newly issued bonds are priced.
Risks that shape bond returns
- Interest rate risk: When market yields rise, prices fall. Duration and convexity describe the size of the move.
- Credit risk: The issuer might miss payments or default. Downgrades by rating agencies can lift required yields and push prices down.
- Liquidity risk: In quiet or stressed markets, it may be costly to trade at size without moving the price.
- Reinvestment risk: Coupons may have to be reinvested at lower rates than assumed in the YTM calculation.
- Call risk: Callable bonds can be redeemed when it suits the issuer, often when yields fall, which caps upside.
- Currency and inflation risk: Holding a bond in a foreign currency adds FX exposure. Higher inflation erodes the real value of fixed coupons and principal unless the bond is inflation linked.
- Structure and legal risk: Covenants, security, subordination and governing law can affect recovery values in stress.
Tax treatment of coupons and capital gains varies by jurisdiction and can change, which affects investors differently depending on their circumstances.
A simple worked example
Imagine a 5-year bond with a face value of 100 and a 4 per cent annual coupon paid once a year. Two investors buy it at different times, facing different market yields.
- When the market yield for this risk and maturity is 5 per cent, the price is below par because the fixed 4 coupon looks less attractive. Discounting each payment at 5 per cent gives a price of about 95.67. The YTM is 5 per cent, higher than the 4 per cent current yield because you also gain as the bond pulls back to 100 at maturity.
- If the market yield later drops to 3 per cent, the same cashflows are worth more. The price rises to roughly 104.58. The YTM falls to 3 per cent, lower than the current yield, because you give up some value as the bond rolls down towards 100 at maturity.
Suppose the bond trades halfway between coupon dates at a clean price of 95.67. The buyer will also pay accrued interest equal to half the annual coupon, which is 2. The dirty price to settle is 97.67 before any fees. Conventions on day-count and settlement timing depend on the market.
This example shows why bond investors watch both price and yield, and why moves in market rates quickly ripple through fixed income valuations.