What Is a Bond? How Bond Prices and Yields Move in Opposite Directions

A bond is a loan in tradable form: the buyer lends money to a government or company, which pays interest at a set rate and repays the principal at maturity. Once issued, a bond can be bought and sold, so its price moves even though its payment schedule does not.

This page covers what a bond is, the four terms that define one, and why price and yield move in opposite directions. It then covers duration, credit risk and quoting, with hypothetical figures only. It is descriptive throughout.

A bond is a loan, put into tradable form

A borrower needing money for longer than one bank will lend can raise it from many lenders at once by issuing a bond. It takes cash on the issue date and promises interest at stated intervals, then repayment on a stated date.

The promise is a security, so the first lender can sell it on and the issuer pays whoever holds it. Foreign holdings of US Treasuries are reported monthly in Treasury International Capital data.

The four terms that define a bond

Four items are set at issue and describe the basic structure of a plain fixed rate bond. Some bonds vary them: a floating rate note resets its coupon with market rates, and an inflation-linked bond adjusts its face value.

• Face value, or par: what is repaid at maturity; here, 1,000 dollars.
• Coupon: the interest the issuer pays, quoted as an annual percentage of face value. Most US bonds pay it in two instalments six months apart.
• Maturity date: the day the face value is repaid and the bond ends.
• Issuer: who owes the money, which decides whether it arrives.

A 1,000 dollar bond with a 4 percent coupon pays 40 dollars a year, and keeps paying 40 dollars until maturity whatever rates do afterwards. The coupon is set in dollars at issue and never moves, which the next section rests on. Inflation still cuts what those fixed dollars buy; a yield with inflation subtracted is the real yield.

Why bond prices and yields move in opposite directions

Yield is the return a bond gives at its current price, and since the payment is frozen the price is the only part that can adjust. Take the bond above, with 10 years still to run: at 1,000 dollars, a 40 dollar coupon returns 40 / 1,000, or 4 percent, the yield at par.

Now suppose newly issued 10 year bonds from the same issuer pay 50 dollars a year on the same face value. Nobody pays 1,000 dollars for the older bond, because that money now buys a 50 dollar coupon instead of a 40. Its price falls until the older bond is worth holding again, which happens at about 923 dollars.

Two things get a buyer at 923 to a competitive return, and beginners usually see only the first. The 40 dollar coupon on a 923 dollar price is 4.3 percent, which is the current yield. The buyer also collects the 77 dollar difference between 923 and the 1,000 repaid at maturity. Count both, spread over the 10 years, and the return works out at 5 percent. That combined figure is the yield to maturity, and it is the number markets mean when they say a bond yields 5 percent.

Nothing about the bond changed; only its price did. The general rule: when yields go up prices go down, and when yields come down prices go up.

Duration: why a long bond moves more than a short one

Two bonds are issued the same day at 1,000 dollars with a 4 percent coupon, one maturing in 2 years and one in 30. Market yields then move up one point, from 4 percent to 5 percent.

The 2 year bond is uncompetitive for two more payments before repaying 1,000 dollars, so at 5 percent it prices near 981 dollars, a fall of roughly 2 percent. The 30 year bond owes thirty years of payments and its repayment is three decades away, so the same arithmetic gives 846 dollars, a fall of roughly 15 percent.

Same coupon, same one point move, about eight times the price impact. That sensitivity is duration, which is why a long bond can lose value in a year when every payment arrived. Duration is quoted in years, but it is not the maturity: the 30 year bond's duration is about 18 years, because the coupons return money long before the face value comes back, and a larger coupon shortens it further.

Credit risk, ratings and the spread

A government borrowing in a currency it issues and a company borrowing in that currency are not making the same promise: if the company runs out of money it can miss a coupon or fail to repay the face value. That is credit risk.

Rating agencies publish letter grades for an issuer's assessed ability to pay, from investment grade down to high yield, but the grades are opinions, revised after the fact, not guarantees.

The price of that risk is the credit spread: the extra yield a bond pays over a government bond of the same maturity. If a hypothetical 10 year government bond yields 4.0 percent and a 10 year bond from a mid rated company yields 5.5 percent, the spread is 150 basis points. The company has to offer that extra 1.5 percent to sell cash flows that would otherwise look identical, and spread moves are watched as a reading of the price of risk.

How bond yields are quoted and where the curve comes from

Government bond markets are discussed in yields, quoted as an annual percentage by maturity: the 2 year, the 5 year, the 10 year, the 30 year. Treasuries themselves still change hands on price, quoted in 32nds of a point per 100 of face value, with the yield derived from it. "The 10 year" usually means one specific benchmark security, the most recently issued 10 year note. A published curve is drawn differently again, from interpolated yields at each maturity rather than from one security per point.

Line those yields up across every maturity and you have a curve, a subject covered in what the yield curve shows. Kresmion publishes a free yield curve tool plotting the US Treasury yield at each maturity.

Yield changes are counted in basis points, one hundredth of a percentage point each, so a quarter of a point is 25 basis points.

Key takeaways

Frequently asked questions

Why do bond prices fall when interest rates rise?

The coupon on an issued bond is fixed in dollars and cannot rise with the market, so if new bonds pay more, the older one competes only by getting cheaper. A 4 percent bond with 10 years left falls to roughly 923 dollars when new bonds of the same maturity pay 5 percent, and a buyer at that price earns 5 percent from the coupon plus the 77 dollars repaid at maturity.

What is the difference between a bond's coupon and its yield?

The coupon is the fixed cash payment, set as a percentage of face value at issue and unchanged for the bond's life. The yield measures that payment against what the bond costs today, so it moves whenever the price moves, and the two match only at face value.

Can you lose money on a bond?

Yes, in three ways. The price can fall below what you paid, so selling before maturity locks in a loss; the issuer can fail to pay; and inflation cuts what the fixed payments buy.

Do bond yields predict what the economy will do next?

No. Yields describe the terms on which borrowing is happening now, and a curve records prices already agreed between buyers and sellers. Some curve shapes have preceded some recessions, which is why they are watched, but a past association is not a forecast.

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Source: bond structure and quoting conventions as described in US Treasury and SEC investor education material. Figures here are hypothetical. This page is information, not investment advice. Kresmion Research.