What Is a Bond? Lending to Governments and Companies

A bond is a tradable loan cut into standard pieces. The issuer sells it for a price, promises to pay a stated rate of interest, the coupon, usually twice a year, and to repay a fixed amount, the face value, on the maturity date. A holder can keep it to maturity and collect the payments, or sell it at any time to someone else, which is what makes it different from a bank loan. The terminology is worth getting straight, because the coupon and the yield are not the same thing:

• •Face value, also called par: the amount repaid at the end, conventionally 100 or 1,000 units
• •Coupon: the annual interest as a percentage of face value, fixed at issue and unchanged for the life of the bond
• •Maturity: the repayment date, ranging from under a year to thirty years or more, with a few countries having issued hundred-year bonds
• •Price: what the bond trades for now, which moves constantly and is usually quoted as a percentage of face value
• •Yield: the return you actually get if you buy at today's price and hold to maturity, which combines the coupon with any gain or loss against face value

The single fact that confuses everyone is that bond prices and yields move in opposite directions, and it follows from the coupon being fixed. Suppose you hold a bond paying 2 percent on a face value of 100 and new bonds of the same type are issued paying 5 percent. Nobody will buy yours at 100 when they can get more elsewhere, so its price falls until the combination of its coupon and the gain to maturity matches what the new ones offer. The fall is larger the longer the remaining life, because a low coupon is being endured for more years, a sensitivity called duration. This is why a rise in interest rates causes losses for bondholders even though nothing has gone wrong with the borrower, and why 2022, in which rates rose faster than at any time in four decades, produced the worst year in the recorded history of the bond market.

Issuers sit on a spectrum of creditworthiness, and the extra yield demanded above the safest borrower is called the spread. Government bonds of a country that borrows in its own currency are the reference point, since such a state can always create the money to pay, so the risk is inflation rather than default; these are gilts in Britain, Treasuries in the United States, bunds in Germany and JGBs in Japan. Governments borrowing in a foreign currency have no such protection and have defaulted repeatedly, as Argentina, Greece, Russia and Sri Lanka have all demonstrated. Companies issue corporate bonds, split by rating agencies into investment grade and, below that, high yield, a category everyone in the market still calls junk. Local authorities, supranational bodies such as the World Bank, and mortgage pools all issue too. The ratings themselves, from agencies including Moody's and Standard and Poor's, are opinions rather than guarantees, a point made painfully in 2008 when large quantities of highly rated mortgage-backed paper turned out to be nothing of the kind.

Plot the yield of a government's bonds against how long they have left to run and you get a curve that is watched closely. Normally it slopes upward, since lending for thirty years deserves more compensation than lending for two, which reflects uncertainty about inflation and the value of having your money back sooner. Occasionally it inverts, with short-dated bonds yielding more than long-dated ones, which means the market expects rates to be cut, which in turn usually means it expects a recession. An inverted curve has preceded every American recession since the 1960s with only one false signal, making it one of the better-known leading indicators, though it says nothing about timing and the lag has ranged from six months to two years. The curve also matters directly, because mortgage rates, corporate borrowing costs and the discount rate applied to company valuations are all set off it.

The traditional case is that bonds do well when shares do badly, since a slowing economy brings rate cuts, which raise bond prices at exactly the moment equities fall, so a mixture is steadier than either alone. That relationship held for most of the period from the 1990s onward and broke in 2022, when inflation drove both down together, which was a reminder that the correlation depends on what is causing the trouble. The other uses are more specific: an insurer or pension fund with known payments due in twenty years can buy bonds maturing then and remove the uncertainty entirely, an approach called matching; index-linked bonds, whose payments rise with inflation, protect purchasing power directly; and a bond held to maturity delivers a known return in nominal terms regardless of what the price does in between, which is a guarantee no share offers.

A bond is a tradable loan with a fixed coupon, a fixed repayment amount and a stated maturity date, and because the coupon never changes, its price falls when prevailing interest rates rise, by more the longer it has left to run. Governments borrowing in their own currency are the safest issuers and set the reference yields, with companies and foreign-currency borrowers paying a spread above them. The slope of the yield curve is a closely watched recession signal, and the traditional role of bonds as a counterweight to shares broke down in 2022.