A bond can pay the same interest every year while its market value falls. There is no contradiction: the interest payment is a promise made by the borrower; the price is what another investor will pay for that promise today. Understanding the difference makes bonds much easier to judge.
Before buying, ask who owes you the money, when you expect it back and what price you are paying. A large coupon is only part of the answer. It can come with a high purchase price, a long wait for repayment or a borrower whose finances are under strain.
A bond makes you a lender
When you buy a share, you own a small part of a company. When you buy a bond, you lend money to its issuer. That issuer might be a government or a business. The bond’s terms set out the interest payments and the maturity date, when repayment is due.
Consider a straightforward fixed-rate bond with a face value of $1,000 and a 4% annual coupon. Face value is the amount used to calculate the interest and, under the terms, repaid at maturity. The coupon is the interest payment: $40 each year in this example.
Face value is not necessarily what you pay. Bonds can be traded between investors. Buy this bond for $920 and its annual coupon remains $40. Buy it for $1,080 and you receive the same $40. The promised repayment remains $1,000, provided the issuer meets its obligations.
Some bonds pay a variable rate; others make no regular interest payments. For now, I am using a plain fixed-rate bond to explain the mechanics. The details of an actual investment come from its terms, rather than from the word ‘bond’ on the sales page.
Why a fixed payment has a changing price
Suppose new bonds with comparable credit risk and maturity offer higher returns. Your existing bond’s lower coupon becomes less appealing. Its price has to fall to offer a competitive return to a new buyer. When the required market return falls, the same fixed payments become more valuable.
Here is the arithmetic with just one year left. A bond will pay $40 interest and repay $1,000 exactly a year from now. That is $1,040 in total. If investors now require a 6% return on a comparable loan, the corresponding price is about $981.13: $1,040 divided by 1.06. Buying at that lower price produces the required 6% return.
Nothing happened to the promised payment. The price changed because buyers wanted a different return. This example assumes full repayment and leaves out fees. A real bond’s price also reflects concerns about the borrower and how easily the bond can be traded.
With other features held equal, a bond with longer to maturity usually moves more sharply when interest rates change. Its payments are locked in further into the future. A twenty-year government bond can therefore carry substantial price risk even when the government’s ability to pay is strong.
Coupon, yield and your actual return
The coupon rate describes interest relative to face value. It does not measure your return on the price you paid. For that, you need the purchase price, income received, eventual sale or repayment amount and costs.
For example, buying our $40-a-year bond for $920 gives a current yield of about 4.35%: $40 divided by $920. That calculation tells you about the annual income relative to your purchase price. It leaves out the extra $80 you would receive if the issuer repays $1,000 at maturity. It also leaves out how long you must wait.
Yield to maturity puts the purchase price and timing of the scheduled payments into one annual figure. It assumes that the issuer pays on time. It generally excludes your trading costs and taxes, and achieving the projected compounded return also depends on the rate available when you reinvest coupons.
Buying above face value works the other way. Suppose you pay $1,080 for a bond with four annual $40 coupons remaining and a $1,000 repayment. If all payments arrive, you receive $1,160 in total. Your gross gain is $80 over those four years, before fees, tax or interest earned by reinvesting coupons. The 4% coupon did not give you 4% a year on your $1,080 investment.
I find that cash calculation more revealing than the headline rate. It makes you account for the price you actually pay instead of treating every $1,000 bond as though it costs $1,000.
Holding to maturity helps, but does not solve everything
If you keep a plain bond until maturity and the issuer pays in full, changes in its quoted price do not alter the scheduled repayment. That can help when matching an investment to a future spending date. It does not remove the risk that the borrower fails to pay.
Your own plans can change too. An unexpected bill or a loss of income might force you to sell sooner. At that point, the market price matters. A year’s interest can be much smaller than the loss on an early sale.
Keep money for surprises separate from investments that you might need to sell at an awkward time. Our guide to how much to keep in an emergency fund starts with the expenses and income risks of your household. A bond maturing years from now does not serve the same purpose as readily available cash.
Check whether the issuer can repay early. A callable bond gives the borrower that right under specified terms. If rates fall and the issuer calls the bond, you may have to reinvest the proceeds at a lower rate. The maturity date on its own will not tell you that.
The borrower matters as much as the rate
Government bonds and corporate bonds describe different borrowers, rather than two fixed levels of safety. Governments differ in their financial strength. So do companies. A higher offered yield can be a warning that the market expects greater difficulty getting paid.
Credit risk is the risk of missing interest or repayment. Credit ratings help investors compare borrowers, but they are assessments, not guarantees. A rating can be cut. Bonds labelled high yield typically have lower credit ratings and a greater risk of default than investment-grade bonds.
Bondholders generally rank ahead of shareholders if a company fails. That does not guarantee full recovery. The assets available and the bond’s position among other debts affect what lenders receive. A subordinated bond ranks behind certain other creditors.
Even a financially strong borrower cannot protect your purchasing power. If prices rise faster than your investment grows, you can end up with more money that buys less. Currency adds another layer: a dollar bond can pay exactly as promised while a weaker dollar reduces the result for an investor who spends in euros or pounds.
There is also liquidity risk. Some bonds are difficult to sell quickly at an acceptable price. Look at the gap between buying and selling prices and the size of the market, rather than assuming a quoted value is what you can collect immediately.
An individual bond is different from a bond fund
An individual bond lets you choose a borrower and a maturity date. It also concentrates your money in that particular loan. A bond fund or bond ETF holds a collection of bonds, making diversification easier. Its costs and investment policy then become part of your decision.
An ordinary ongoing bond fund replaces bonds as they mature or are sold. Your fund holding therefore does not come with the same single maturity date and face-value repayment as an individual bond. You sell units at their market value. Funds designed around a target maturity year also exist; their own terms explain how they wind down.
A fund owning long-term government debt is a different investment from one owning short-term lower-rated corporate debt. Both can lose value. Check the underlying borrowers, maturities, currencies and annual costs. A familiar fund name is not a substitute for knowing what it owns.
Give bonds a job in your plan
Bonds can diversify a portfolio, but they do not automatically rise whenever shares fall. In an inflation shock, both can decline. Before changing the mix, think about when you need the money and which losses you could withstand. The questions in buying stocks when the market falls are useful here too: a cheaper price only helps if the investment fits your time horizon.
Compare the total amount you pay with the quoted bond price. Interest built up since the last coupon payment can be added at settlement, alongside trading fees. Ask about early repayment terms and what an early sale would cost. These details can matter a great deal for a small investment.
Before buying, I would want to explain the source of the return in a few plain sentences. Is it interest, a discount to the repayment amount, or a hope of selling at a higher price? If market movements keep pulling you away from that plan, our guide to investing stress and sticking to a plan can help you separate an uncomfortable price move from a reason to change course.