Bonds are boring, but smart investors use them for stability, diversification, and upcoming withdrawals. Understanding some basics will help you evaluate the risks and rewards of owning bonds in your portfolio.

What is a Bond?

A bond is essentially an “I.O.U.” You become a bondholder when you lend money to the government, a corporation, or a municipality. In exchange for your money, the bond issuer promises to pay interest periodically and repay principal equal to the bond’s face value at the end of a specific time period.

Consider a company that needs to build a new facility costing $2 million. The company decides to borrow the money to fund construction by issuing 200 bonds for $10,000 each to investors. In this case, $10,000 represents the “face value” of each bond. Prior to issuing the bonds, the company takes into account market factors and establishes an annual interest rate, or “coupon,” that it will pay on each bond to entice investors to purchase them. The company also determines the bond’s “maturity,” the date when it will repay the face value to the bondholders. So, if the company decides to issue 5-year bonds paying a 6% coupon, then each holder of a bond can expect to receive $600 per year in interest income ($10,000 face value x 6% coupon rate) plus the $10,000 face value at the end of five years.

Originally a physical paper bond came with a bond for repayment of the loan along with perforated coupons, one per interest payment. Bond holders would redeem the coupon for each interest payment. Rather than requiring a monthly redemption, bond interest was typically paid every six months. In our example, each six month coupon would be redeemed for $300.

The Bond Market

When an entity issues bonds to raise money, it does so through an initial offering in the primary market where most bond buyers are large institutional investors such as broker-dealers and mutual funds. After the initial offering, bonds trade freely between investors in the secondary market much like stocks do. As an individual investor, you are usually buying your bonds in the secondary market from another investor who wishes to sell before maturity. A bond’s price in the secondary market fluctuates daily around its face value to reflect changes in market interest rates.

Consider a bond from our example above. At the initial offering, its face value is $10,000. If you missed the initial offering and want to buy this bond in the secondary market, you probably will not buy it for its $10,000 face value. More likely, you would buy it at either a “discount” to face value or at a “premium” to face value depending on whether market interest rates have gone up, down, or stayed the same since the initial offering.

For example, the same $10,000 face value bond could now be valued at $9,900 (at a $100 discount) or valued at $10,100 (at a $100 premium) in response to interest rate changes. However, regardless of its current price, the bond still pays $600 in annual interest. The fact that you can buy a bond in the secondary market at a price different from its stated face value is one of the main sources of confusion about bonds.

Bond Prices and Interest Rates

Bond prices fluctuate daily in response to both changes in market interest rates and the credit quality of the underlying issuer. As a bondholder, you should be aware that the price of a bond has an inverse relationship to changes in the market interest rates. If market interest rates rise, then the price of an existing bond usually falls because it pays a lower rate than you can earn by buying a new bond in the market.

Let’s say your $10,000 bond paying 6% matures in 5 years. One year after you buy it market interest rates rise to 7%. Your bond is now worth $9,584. Why? If you now want to sell your bond in the market, the price must fall to a point where another investor can earn 7% by buying it and holding it to maturity in 5 years. The $600 annual coupon payment is 7% if the bond is discounted and sold for $9,584.

Bond pricing is complex , but can be reduced to the addition of the present value of each of the future $600 coupon payments ($2,495.98) and the present value of the $10,000 cash flow at the end of 5 years ($7,089.19). Adding the value of the annuity stream to the value of the lump sum payment at the end determines the value of the bond.

Conversely, if market interest rates fall, then the price of an existing bond typically rises because it pays a higher rate than you can earn by buying a new bond in the market. Using the example above, if market interest rates fall to 5% one year later, your bond is now worth $10,438. You can sell it for a capital gain or keep it and earn 6% until maturity.

Changes in interest rates do not affect the prices of all bonds equally. The longer it takes for a bond to mature, the more sensitive the bond price is to interest rate changes. The longer your interest rate is locked, the more your bond will fluctuate in value when interest rates change. Therefore the price of a 20-year bond moves up and down more than a 2-year bond. If you plan to hold your bond to maturity, these changes are on paper only and represent the value of your bond in relation to the new bonds you could invest in.

Bond Risks & Returns

Buying bonds carries three risks. First, your purchasing power could be lost through inflation by the time your bond matures.  When you get your money back, it won’t buy as much.

Second, your bond could be worth less than your purchase price if you need to sell your bond before maturity and interest rates have risen.

And third, the bond issuer could default, stop paying interest and fail to return your investment. Like stocks, each of these risks can be reduced through diversification by purchasing bonds with different maturities, credit qualities, industries and countries.

Bonds are like the iron rods put in the bottom of sailing ships. They don’t make the ship go faster, but they do keep the ship from capsizing in stormy weather. Bonds can keep a portfolio afloat in stormy markets. Normally investing in bonds earns less than investing in stock, but during volatile markets holding bonds can boost returns. A financial professional can help you navigate the complex world of bonds and tailor your bond allocations to best meet your financial objectives.

A version of this article was originally published October 23, 2006. Photo by Tobias Fischer on Unsplash.