How Bonds Work

If a stock makes you an owner, a bond makes you a lender. Bonds are the part of a portfolio meant to be steady: they pay a known stream of interest and return a set amount at the end. Yet bond prices can fall, sometimes sharply, and many investors first learn this when their "safe" fund shows a loss. This chapter explains how a bond works, why its price moves opposite to interest rates, the main kinds of bonds, and what they can and cannot do for a portfolio.

How a bond works

A bond is a loan with fixed terms, written so the lender can sell it to someone else. The borrower, called the issuer, may be the US Treasury, a government agency, a state or city, or a company. The terms are set when the bond is issued.

• Face value (par). The amount the issuer repays at the end. Coupons and prices are quoted as a percentage of it, so a price of 95 means 95% of face value.
• Coupon. The yearly interest, stated as a percentage of face value. A 4% coupon pays 4% of face value each year, usually in two half-year payments.
• Maturity. The date the face value is repaid and the bond ends. Bills mature within a year, notes in two to ten years, and bonds in longer terms.
• Credit rating. A grade from a rating agency on how likely the issuer is to pay in full and on time.

Once issued, a bond trades at a market price that can be above or below its face value. Two yields describe what a buyer earns at that price. The current yield is the coupon divided by the price. The yield to maturity is the total yearly return if you buy at today's price, receive every payment, and hold until the face value is repaid. It is the better single number for comparing bonds.

For a sense of current levels, a 26-week Treasury bill yielded 4.37% on September 29, 2026. Yields change daily, and the Treasury publishes them on its website.

Why bond prices move opposite to interest rates

This is the most important idea in bond investing. When market interest rates rise, the prices of existing bonds fall. When rates fall, existing bonds rise in price.

The reason is competition. Suppose you hold a bond paying 4% and new bonds of the same kind now pay 5%. No buyer will pay full price for your 4% bond when a 5% bond is on offer. The examples below show what the extra point is worth to a buyer over ten years.

At 5% the money reaches about $16,289, against about $14,802 at 4%. To make your old bond as attractive as a new one, its price has to fall until a buyer's yield to maturity matches the 5% now available. For a 10-year bond with a 4% coupon, a one-point rise in rates cuts the price by roughly 8%.

Two consequences follow. First, if you hold an individual bond to maturity and the issuer pays, you receive the face value regardless of what rates did in between; the price swings matter only if you sell early. A bond fund never matures, so its price keeps moving with rates. Second, longer bonds swing more, because the lower coupon is locked in for more years. Chapter 6 introduces duration, the number that measures this sensitivity.

This is not theoretical. In 2022, when interest rates rose quickly, a 10-year Treasury bond returned -17.83%, its worst calendar year in the 1928 to 2025 record. The money was not at risk of default; the loss came entirely from rising rates.

The main kinds of bonds

Treasuries. Issued by the US government and backed by its full faith and credit, they are treated as the benchmark for safety from default. Their interest is taxed by the federal government but exempt from state and local income tax. You can buy them through a brokerage or directly from TreasuryDirect, where bills are sold in multiples of $100.

Treasury Inflation-Protected Securities (TIPS). The principal rises with consumer prices, and the fixed coupon is paid on the adjusted principal, so both the income and the final repayment keep pace with inflation. At maturity you receive the adjusted principal or the original, whichever is higher. The 10-year TIPS yield, a real yield above inflation, was 2.91% on September 29, 2026.

Series I savings bonds. Bought only from TreasuryDirect, up to $10,000 in electronic bonds per person per calendar year. They pay a fixed rate plus an inflation rate reset every six months, never fall in value, cannot be cashed in the first year, and lose three months of interest if cashed within five years.

Municipal bonds. Issued by states, cities and their agencies. Their interest is usually exempt from federal income tax, and often from state tax for residents of the issuing state. They pay lower yields than comparable taxable bonds, so whether they pay off depends on your tax bracket, as the next example shows.

Corporate bonds. Issued by companies. They pay more than Treasuries to make up for the risk that the company cannot pay. Bonds rated BBB or higher are called investment grade. Those rated BB or lower are called high yield, or junk, and tend to fall along with stocks in a recession, which is exactly when you would want bonds to hold up.

To compare a municipal bond with a taxable one, divide the tax-free yield by one minus your federal marginal tax rate. The marginal rate depends on income and filing status; here is one example under 2026 law.

This filer's top federal bracket is 24.0%. For them, a tax-free yield of 3% is worth about the same as a taxable yield of 3% divided by 0.76, or about 3.9%. In a lower bracket the advantage shrinks, and inside a retirement account, where interest is not taxed each year anyway, it disappears.

What bonds do in a portfolio, and what they do not

Bonds earn their place in three ways. They pay steady income. High-quality bonds offer capital preservation: the face value comes back at maturity. And they often provide ballast: when stocks fall in a recession, interest rates tend to fall too, lifting the price of high-quality bonds. In 2008, US large-company stocks returned -36.55% while a 10-year Treasury returned 20.1%.

That cushioning is common, not guaranteed. In 2022, stocks returned -18.04% and the same Treasury bond returned -17.83%: rising rates hurt both at once.

Bonds carry their own risks. Interest-rate risk is the price swing described above. Inflation risk is the chance that fixed payments buy less over time; a 4% coupon during 5% inflation is a loss in real terms, which TIPS and I bonds are designed to avoid. Credit risk is the chance the issuer cannot pay. Call risk is the issuer's right, on some bonds, to repay early when rates fall, just when you would want to keep the higher coupon.