Bonds & Interest Rates · Beginner · 4 min

What is a bond?

You can explain what a bond is, how a bondholder earns, and which risks remain even though the payments are agreed in advance.

Owner or lender?

When you buy a share, you become a part owner of a company. When you buy a bond, you become something else: a lender. The company or government owes you money, on dates written down in advance.

That one difference changes how you earn, what you can lose and how the price behaves. Bonds are one of the largest markets in the world, and they influence everything from mortgages to share prices.

Lend, earn, get it back

A bond is a loan. The issuer, a government, a city, a company or a bank, borrows money from investors and promises two things:

to pay interest, usually at fixed dates, and
to repay the amount borrowed when the bond matures.

Because the payments are fixed in advance, bonds are often called fixed income. As a bondholder, you are a creditor. If the issuer gets into trouble, creditors rank ahead of shareholders.

That does not remove the risk. The SEC and FINRA name the main risks:

Credit risk: the issuer may not pay interest or repay on time, or at all.
Interest rate risk: when market interest rates rise, the price of existing fixed-rate bonds falls, because new bonds pay more. This matters if you sell before maturity.
Inflation risk: fixed payments buy less when prices rise.
Liquidity risk: some bonds trade rarely, so selling early can be costly.

Bonds trade after they are issued, mostly over the counter between dealers, and their prices move every day. A bond fund or ETF holds many bonds and has no single maturity date, which changes how it behaves compared with a single bond.

40 a year, 1,000 back

A fictional company issues a five-year bond with a face value of 1,000 and an interest rate of 4%.

The investor pays 1,000 at issue.
Each year, the company pays 40 in interest: 200 over five years.
At maturity, the company repays the 1,000.

If the company stays healthy, the investor receives exactly 1,200 in total. If it fails in year three, the investor may receive only part of the 1,000, after a long insolvency process.

Common mistakes

"Fixed income means no risk." Prices move, and issuers can fail.
Ignoring who the issuer is. A loan is only as good as the borrower.
Forgetting inflation. A fixed 4% is worth less when prices rise by 5%.
Treating bond funds like single bonds. A fund has no fixed repayment date.

The takeaway

A bond is a loan you give to a government or company. You receive interest and your money back at the end, if the borrower can pay.

Check yourself

Quick quiz

4 questions. Instant feedback, nothing is saved.

1Tap the step in which a bondholder receives regular income.

Tap the chart.

Most bonds pay a fixed interest at set dates until they mature.
2If a company fails, who is usually paid before its shareholders?

Bondholders are creditors. They rank ahead of shareholders, though they may still lose part of their money.
3You hold a bond, and market interest rates rise sharply. What happens to its price before maturity?

The SEC calls this interest rate risk. New bonds pay more, so older ones with lower interest become less attractive.
4What is the issuer of a bond?

The issuer borrows and promises to pay interest and repay the principal.

of 4 correct.