Bond Basics: How Fixed-Income Securities Work

Key Takeaways

• A bond's four defining numbers are face value, coupon rate, maturity date, and market price.
• When market yields rise, existing bond prices fall; when yields fall, prices rise.
• Bondholders rank above equity holders in a default, giving them greater repayment priority.
• Credit risk and interest-rate risk are distinct: a 30-year Treasury has high rate risk but near-zero credit risk.

What It Is

When a company, municipality, or government needs to raise cash, it can issue a bond. The investor who buys the bond is the lender. The issuer is the borrower. The contract spells out how much interest will be paid, when, and the date the loan must be repaid in full.

Four numbers define almost any bond you will meet:

• Face value (also called par value or principal). The amount the issuer repays at maturity. Corporate bonds in the US are usually sold in $1,000 denominations.
• Coupon rate. The annual interest rate applied to face value. A 5 percent coupon on a $1,000 bond pays $50 per year, typically in two $25 semi-annual installments.
• Maturity date. The date the principal is returned and the bond stops paying interest.
• Price. What the bond actually trades for in the market, which can be above, below, or equal to face value.

The Intuition

Stocks give you a slice of ownership and an uncertain payoff. Bonds give you a contractual cash-flow schedule. If the issuer stays solvent, you know exactly what you will receive and when. That predictability is why pensions, insurers, and retirees hold large bond allocations.

The tradeoff is upside. A bondholder cannot benefit from the issuer's growth the way a shareholder can. Your return is capped at the coupons plus any price movement between purchase and sale. In exchange, bondholders sit higher in the capital structure, meaning they get paid before equity holders if the issuer runs into trouble.

How It Works

Bonds are created in the primary market through underwritten offerings or Treasury auctions. After issuance, they trade in the secondary market, mostly over-the-counter between dealers and institutions. Prices are quoted as a percentage of par. A price of 98 means 98 percent of face value, or $980 on a $1,000 bond. A price of 102 means $1,020.

Three simple relationships come up constantly:

If coupon rate = market yield, price = par (100)
If coupon rate > market yield, price > par (premium)
If coupon rate < market yield, price < par (discount)

Bond features that change the basic contract:

• Callable. The issuer can redeem the bond early, usually after a lock-out period, by paying a call price. Issuers call when rates drop and they can refinance cheaper.
• Putable. The holder can force early redemption. Rare, and favors the investor.
• Secured vs unsecured. Secured bonds have specific collateral behind them. Unsecured bonds rely only on the issuer's general credit.
• Senior vs subordinated. In a default, senior debt is paid first. Subordinated debt ranks below and carries a higher coupon to compensate.
• Fixed vs floating coupon. Floating-rate notes reset their coupon periodically against a reference like SOFR.

Bonds are rated by agencies such as Moody's, S&P, and Fitch. Investment grade runs from AAA/Aaa down to BBB-/Baa3. Anything below that is called high-yield or junk and compensates with a higher coupon.

Worked Example

A five-year corporate bond is issued at par with a 4 percent annual coupon. Face value is $1,000.

• Year 1 through 4: the issuer pays $40 per year in coupons.
• Year 5: the issuer pays the final $40 coupon plus the $1,000 principal.

Two years later, prevailing yields on similar bonds have risen to 6 percent. New buyers will not pay $1,000 for a bond that only pays $40 when they could buy a new one paying $60. The existing bond's market price drops to roughly $930 so its future cash flows produce a 6 percent yield for a new buyer. The original holder is sitting on a paper loss, even though the issuer has done nothing wrong and will still pay every coupon on time. That is interest-rate risk in one paragraph.

Common Mistakes

1. Forgetting the price-yield inverse. When market yields rise, the price of existing bonds falls, and vice versa. This is not a quirk. It is the core mechanic of fixed-income markets. The 2022 Treasury selloff wiped out a decade of gains for long-duration bond funds, and many investors were shocked because they thought bonds were always safe.

2. Confusing credit risk with interest-rate risk. Credit risk is the chance the issuer fails to pay. Interest-rate risk is the chance that rising yields push the market price of a bond down even if the issuer is perfectly healthy. A 30-year Treasury has essentially zero credit risk and enormous interest-rate risk. A short-term junk bond is the opposite. Own both risks knowingly.

3. Treating bonds as risk-free. Even Treasuries can lose 15 to 20 percent of their market value in a sharp rate-hike cycle. Only a bond held to maturity with no default pays exactly what the contract promised. Anything sold before maturity prints a mark-to-market gain or loss.

4. Ignoring accrued interest when buying. Between coupon dates, a buyer pays the seller the clean price plus the interest that has accrued since the last coupon. Your brokerage confirmation shows both. Budget for it.

5. Assuming coupon income and price gains are taxed the same. Coupon interest is usually taxed as ordinary income at the federal level. US Treasuries are exempt from state tax. Qualified municipal bonds can be exempt from federal tax. Bonds bought at a discount to par may generate taxable accretion each year even though no cash changes hands. Tax treatment varies by bond type and jurisdiction, and it can materially change after-tax yield.

Frequently Asked Questions

What is the difference between a bond's coupon rate and its yield? The coupon rate is the fixed annual interest payment divided by face value, set at issuance and never changing. Yield reflects the return a buyer actually earns given the current market price, which fluctuates daily, so yield and coupon rate diverge whenever the bond trades away from par.

Can you lose money owning bonds? Yes. If you sell before maturity and market yields have risen since you bought, the bond's price will be lower than what you paid, producing a capital loss. Default by the issuer can also result in partial or total loss of principal, even before maturity.

What does it mean when a bond trades at a premium or discount? A bond trades at a premium when its coupon rate exceeds current market yields, so investors pay more than face value. It trades at a discount when its coupon rate is below current yields, pushing the price below par. Both situations normalize to par value at maturity.

How does the capital structure affect bond safety? Senior secured bondholders have first claim on specific collateral in a default. Senior unsecured follows, then subordinated debt, and equity holders come last. Bonds higher in the capital structure receive more recovery in a restructuring and therefore carry lower yields than subordinated instruments from the same issuer.

Why do pensions and insurers hold so many bonds? Their liabilities, such as future pension payments or insurance claims, are contractual and long-dated. Bonds provide matching predictable cash flows and known maturity values that align with those obligations. Equities offer higher expected returns but with volatility that makes liability matching unreliable.

Sources

1. SEC Investor.gov. "What Are Corporate Bonds?" https://www.investor.gov/introduction-investing/general-resources/news-alerts/alerts-bulletins/investor-bulletins/what-are
2. SEC Investor.gov. "Bonds FAQs." https://www.investor.gov/introduction-investing/investing-basics/investment-products/bonds-or-fixed-income-products/bonds
3. FINRA. "Bonds: Key Terms." https://www.finra.org/investors/investing/investment-products/bonds/key-terms
4. FINRA. "Understanding Bond Yield and Return." https://www.finra.org/investors/insights/bond-yield-return
5. TreasuryDirect. "Treasury Bonds." https://www.treasurydirect.gov/marketable-securities/treasury-bonds/

Disclaimer

This article is educational content only and is not financial advice. Nothing here is a recommendation to buy, sell, or hold any security. Consult a licensed advisor before making investment decisions.