Bonds explained: how they work and why prices move with interest rates

When you buy a bond, you lend money to the issuer, which may be a government or a company. In return, you receive interest payments and get your principal back on a set date. Bonds are one of the main building blocks of a diversified portfolio, and they behave quite differently from shares. This article explains the key terms, why bond prices move when interest rates change, the main risks and how bonds fit into a portfolio.

The key terms

• Face value (or par): the amount repaid at maturity, often 1,000 per bond.
• Coupon: the interest the bond pays, usually a fixed percentage of face value. A 3% coupon on a 1,000 bond pays 30 a year.
• Maturity: the date the bond is repaid. It can range from a few months to 30 years or more.
• Yield: the return you earn given the price you pay. If you buy below face value, the yield is higher than the coupon, and vice versa.
• Issuer: who is borrowing. Governments, municipalities and companies all issue bonds.

Why bond prices move when rates move

This is the most important idea. Suppose you hold a 10-year bond with a 3% coupon, and market interest rates then rise so that new similar bonds pay 5%. Nobody wants your 3% bond at full price when they can get 5% elsewhere. Its price must fall until its yield is competitive.

Here are illustrative figures. A 1,000 bond with a 3% coupon and 10 years to maturity:

• If market yields rise to 5%, its price falls to about 846.
• If market yields fall to 1%, its price rises to about 1,189.

If you hold the bond to maturity, you still receive the face value and all coupons, so the price movements matter less unless you need to sell early. The longer the maturity, the larger the price swing for a given change in rates. A measure called duration summarises this sensitivity.

The main risks

• Interest-rate risk: prices fall when rates rise, as above.
• Credit risk: the issuer might fail to pay. Credit rating agencies grade issuers. Bonds rated investment grade are considered lower risk, while high-yield, or "junk", bonds pay more to compensate for higher default risk.
• Inflation risk: a fixed coupon loses purchasing power if prices rise faster than expected.
• Liquidity risk: some bonds are hard to sell quickly at a fair price.
• Reinvestment risk: when a bond matures or pays coupons, you may only be able to reinvest at lower rates.
• Currency risk: for bonds issued in a foreign currency.

Types of bonds

• Government bonds: issued by national governments. Bonds from stable governments in their own currency are generally viewed as among the lowest in credit risk.
• Corporate bonds: issued by companies, with higher yields for higher risk.
• Municipal or regional bonds: issued by local authorities, sometimes with tax advantages depending on the country.
• Inflation-linked bonds: payments adjust with inflation, which can help preserve purchasing power.
• Short-term versus long-term bonds: short-term bonds are less sensitive to rate changes, while long-term bonds are more sensitive.

Individual bonds or bond funds

You can hold individual bonds, or buy a fund or ETF that holds many of them. Individual bonds have a maturity date, so if you hold to maturity you know what you will receive, barring default. A bond fund has no maturity date and its value changes with rates, but it offers diversification and convenience, and you can invest small amounts. Check the fund's average maturity or duration and credit quality so you know what risk you are taking.

The role of bonds in a portfolio

Bonds often play a stabilising role. They tend to fluctuate less than shares, they provide regular income, and they sometimes rise when shares fall, though this is not guaranteed. A mix of shares and bonds can make the ride smoother, which helps many investors stay invested. The right amount depends on your time horizon and risk tolerance. As you approach a goal such as retirement, many investors increase their share of bonds.

Common mistakes

• Assuming bonds are risk-free. They are not, as the price figures above show.
• Reaching for the highest yield without considering the credit risk behind it.
• Buying long-term bonds with money you may need soon.
• Ignoring inflation when judging whether a yield is attractive.
• Holding a bond fund without knowing its duration or quality.

A short checklist

• I understand the coupon, maturity and yield of what I hold.
• I know how sensitive my bonds are to interest-rate changes.
• I have checked the credit quality of the issuers.
• My bond holdings match my time horizon.

Bonds are not exciting, but they play a vital role. Knowing how they work helps you use them with confidence.