Learning Objectives

By the end of this lesson you will be able to:

• Define a bond and explain the relationship between the lender and borrower
• Identify the key terms of a bond: face value, coupon rate, maturity, and yield
• Explain the inverse relationship between bond prices and interest rates
• Distinguish between government bonds, corporate bonds, and municipal bonds
• Describe when and why bonds belong in a portfolio

Core Content

What Is a Bond?

A bond is a fixed income security — a formal loan agreement between an investor (the lender) and an issuer (the borrower). The issuer can be:

• A national government (U.S. Treasury bonds, T-bills, T-notes)
• A state or local government (municipal bonds)
• A corporation (corporate bonds)
• An agency (Freddie Mac, Fannie Mae)

1. Pay the investor a fixed rate of interest (the coupon) at regular intervals
2. Return the original principal (face value) at the end of the term (maturity)

Key Bond Terms

Face value (par value): The principal amount of the bond — typically $1,000 per bond. This is the amount the issuer will return at maturity.

Coupon rate: The annual interest rate paid on the face value. A $1,000 bond with a 5% coupon pays $50 per year in interest.

Maturity: The date when the issuer repays the principal. Maturities range from 90 days (T-bills) to 30+ years (long-term government bonds).

Yield: The actual annual return you earn based on the price you paid for the bond. Yield and coupon rate differ when the bond is purchased above or below face value.

The Price-Yield Relationship

Bond prices and interest rates move in opposite directions. This is one of the most important principles in fixed income.

When market interest rates rise, newly issued bonds offer higher yields. Existing bonds with lower coupons become less attractive, so their prices fall until their yield matches the new market rate.

When market interest rates fall, existing bonds with higher coupons become more attractive, so their prices rise.

Practical implication: If you buy a bond and hold it to maturity, price fluctuations do not affect your return — you receive every coupon payment and your full principal back. Price risk only affects you if you sell before maturity.

Types of Bonds

U.S. Treasury bonds: Issued by the federal government. Considered essentially risk-free for default (the U.S. government can print currency). The benchmark for global fixed income.

Municipal bonds: Issued by state and local governments. Interest is typically exempt from federal income tax — especially valuable for investors in high tax brackets.

Corporate bonds: Issued by companies. Yield more than government bonds to compensate for higher default risk. Investment-grade corporate bonds carry lower default risk than high-yield (junk) bonds.

International bonds: Issued by foreign governments or corporations. Carry currency risk in addition to interest rate and default risk.

When Bonds Belong in a Portfolio

Bonds serve two roles:

1. Income generation — bonds provide predictable, regular cash flow
2. Risk reduction — bonds typically hold value better than equities during market downturns

A common rule of thumb: your age in bonds (a 30-year-old holds 30% bonds). This is a starting point for thinking, not a prescription.

Application

Before proceeding to the next lesson, complete the following:

1. Look up the current yield on the 10-year U.S. Treasury bond. Record the number and note whether it is above or below the current inflation rate.
2. Look up one corporate bond ETF (such as LQD or BND). Record the current yield and the fund's one-year price change.
3. Write a sentence describing how you would feel holding a bond position that lost 10% in market value while interest rates rose, knowing you plan to hold it to maturity.