How Bonds Work: The Other Half of the Market

A bond is a loan. You lend money to a government or corporation, they promise to pay you interest on a schedule, and return your principal at a specified maturity date. That's the entire concept. The complexity comes from how bond prices behave after issuance.

The Basic Terms

Face value (par): The amount the issuer will repay at maturity. Usually $1,000 per bond.
Coupon rate: The annual interest rate stated on the bond. A 4% coupon on a $1,000 bond pays $40 per year, typically in two $20 installments.
Maturity date: When the issuer returns your principal.
Yield: The actual return you get based on what you paid for the bond. If you buy a 4% coupon bond for $950, your effective yield is higher than 4%.

The Inverse Relationship: Rates Up, Prices Down

This is the part people find confusing. If you own a bond paying 4% and interest rates rise to 6%, your bond is less attractive (new bonds pay 6%). To sell your bond, you must lower the price until the buyer's effective yield equals current market rates. Bond prices and interest rates move in opposite directions.

The longer the maturity, the more sensitive the bond is to rate changes. A 30-year bond drops in value far more than a 2-year bond when rates rise by the same amount. This sensitivity to rate changes is called duration risk, and it's why long-term bonds are not the "safe" investment they're sometimes marketed as.

Government vs. Corporate Bonds

US Treasury bonds: Backed by the federal government. Essentially zero default risk. Yields are lower as a result. The 10-year Treasury yield is the global benchmark for the risk-free rate.
Municipal bonds (Munis): Issued by state and local governments. Interest is often exempt from federal income tax, making them attractive in higher tax brackets.
Corporate bonds: Issued by companies. Higher yield than Treasuries to compensate for default risk. Rated by agencies (Moody's, S&P): investment-grade vs. high-yield ("junk").

The Role of Bonds in a Portfolio

Bonds are typically less volatile than stocks and generate predictable income. In a crisis, investors often move into Treasuries (flight to safety), which raises Treasury prices even as stocks fall. This is why a traditional portfolio holds both: stocks for growth, bonds for stability and income.

The classic 60/40 portfolio (60% stocks, 40% bonds) underperformed badly in 2022, when both stocks and bonds fell simultaneously due to rapid rate increases. That was unusual but not unprecedented. Bonds reduce volatility on average; they don't eliminate it.

Bonds are the boring half of the portfolio. Boring is what lets you stay invested when the exciting half is scary.