How Bonds Work: Price, Yield, Maturity and Default Risk

Ramesh is told to hold more bonds

Ramesh is a few years from retiring, and the advice arriving from every direction is the same: move some of it out of equity and into bonds. It sounds like a move from the thing that goes up and down to the thing that does not.

That is not what a bond is. Bonds move too, sometimes a great deal, and the most common reason has nothing to do with anybody failing to pay. Before deciding how many to own it is worth knowing what one actually is — because the surprises come from the resale market rather than from the borrower.

A loan with a resale market

When Ramesh buys a bond he is lending money to the issuer — a government, a company, a bank — and in return they promise two things: interest payments on a schedule, and the return of the principal on a stated date.

If that were all, bonds would be simple. What makes them interesting is that the loan is transferable: he can sell it to somebody else before it matures, at whatever price they will pay that day.

That resale market is where every complication comes from. A fixed deposit has no resale market, so its value never moves. A bond's does, and the price is set by what a buyer thinks the remaining payments are worth today.

The four numbers, and how they relate

Face value is what the issuer repays at maturity, and it does not change. The coupon is the interest, usually a fixed percentage of face value, paid on a schedule, and for a conventional bond it does not change either. Price is what the bond trades at today, and this moves. Yield is the return you would actually earn buying at today's price and holding to maturity, combining the coupon with the gain or loss from having bought above or below face value.

The relationship worth internalising is that the coupon is fixed, so if the price moves the yield must move the opposite way. Buy the same fixed stream of payments for less and you earn more; buy it for more and you earn less. Price and yield move in opposite directions, and every confusing headline about bonds becomes readable once that is automatic.

Why prices fall when rates rise

This is the part that surprises people who think of bonds as safe, and it is the mechanism behind most of what Ramesh will see on his statements.

Suppose he holds a bond paying a fixed coupon. New bonds are then issued paying more, because prevailing rates have risen. Nobody will buy his bond at its old price — why accept a smaller income when a larger one is available? So the price of his bond falls until the yield a buyer would earn matches what they could get elsewhere.

Nothing has gone wrong. The issuer has not missed a payment and is not in difficulty. His bond is worth less because the alternatives got better.

Two consequences follow. If he holds to maturity and the issuer pays, the price fall does not cost him money — he receives his coupons and his face value as promised, and the fall was a change in what he could have sold for rather than in what he was owed. But if he sells before maturity, or holds the bond through a fund reporting a daily value, the fall is entirely real to him. This is why people are surprised by losses in debt funds: the fund's value reflects what the bonds would fetch today.

How long you wait decides how much it moves

Not all bonds react equally to a change in rates, and the difference is simply how far the remaining payments stretch into the future.

The intuition is worth having. If rates rise, a bond maturing next year is only stuck with its below-market coupon briefly, then repays and the money is reinvested at the new higher rate. A bond maturing in twenty years is stuck for twenty years, so the disadvantage is much larger and the price has to fall considerably further to compensate a buyer.

That sensitivity has a formal measure, duration, which is the subject of its own page. The rule to carry from here is simply that longer bonds move more, in both directions.

Default risk is a different risk entirely

Everything above assumes the issuer pays, and credit risk is the possibility that they do not.

The two risks behave differently, and keeping them separate is worth the effort. A rate-driven price fall reverses as the bond approaches maturity and disappears entirely if the issuer pays. A default is permanent: money not repaid does not come back except through recovery proceedings, which are slow and partial.

Issuers are rated by agencies, and the ratings are a useful starting point rather than a verdict. They are opinions, they get revised — sometimes abruptly, and usually after the market has already noticed — and a rating is a statement about relative likelihood rather than a guarantee.

The more reliable signal is the yield itself. If a bond offers a much higher yield than comparable alternatives, the market is pricing in a risk, and it might be credit risk, illiquidity, or an option buried in the terms. Extra yield is always payment for accepting something, and if you cannot identify what, you have not finished analysing it.

The risks that are easy to miss

Reinvestment is the first: coupons arrive along the way, and if rates have fallen they get reinvested at lower rates, so the realised return ends up below the yield originally quoted.

Liquidity is the second. Many bonds trade rarely, so selling in a hurry means accepting whatever a buyer offers, and in stressed conditions there may be none at a sensible price. This matters more for individual bonds and for funds holding thinly traded paper.

Call options are the third. Some bonds let the issuer repay early, and they will do so when it suits them — typically when rates have fallen and they can refinance cheaply — which removes exactly the attractive high-coupon bond you wanted to keep.

And inflation is the fourth. A fixed coupon buys less over time, and for a long-dated bond that erosion may cost more purchasing power than any price movement, while never appearing as a loss on a statement.

Government against corporate

Government bonds carry the lowest credit risk in their own currency, since the issuer controls the currency. That does not make them safe in every sense — they still fall in price when rates rise, and long-dated government bonds can fall substantially. "No credit risk" and "no risk" are different statements, and conflating them is the specific error behind surprise losses in gilt funds, which has its own page.

Corporate bonds pay more because they carry credit risk and often less liquidity. Whether the extra is adequate compensation is the whole question, and it cannot be answered by looking at the yield alone.

What to take away

A bond is a transferable loan. The coupon is fixed, so when the price moves the yield moves the other way, and prices fall when prevailing rates rise — which is not a sign of trouble at the issuer.

Hold to maturity and a rate-driven fall costs you nothing, provided the issuer pays. Sell earlier, or hold through a fund, and it is real. Longer bonds move more. And any yield noticeably above comparable alternatives is payment for a risk — your job is to find out which one before you accept the payment.