How Bonds Work
When a government or company issues a bond, it receives cash from investors, pays coupon interest at set intervals, and returns the face value at maturity. For example, a $1,000 bond with a 5% coupon and 2-year maturity pays $50 per year and returns $1,000 at the end.
Bonds also trade on secondary markets. When prevailing interest rates rise, existing bonds become less attractive and their prices fall. When rates fall, bond prices rise — an inverse relationship.
Types of Bonds
Government Bonds: Issued by national governments (US Treasuries, UK Gilts, German Bunds). Considered lowest credit risk. Yields act as the "risk-free rate" benchmark.
Corporate Bonds: Issued by companies. Offer higher yields than government bonds to compensate for default risk. Investment-grade vs. high-yield (junk) distinctions are based on credit ratings.
Emerging Market Bonds: Issued in foreign currency (USD/EUR) by developing-country governments. Higher yields but carry currency and sovereign risk.
Bond Price and Interest Rate Relationship
If you hold a 3% coupon bond and new bonds are being issued at 5%, your bond is less attractive — its price falls until its effective yield matches 5%. This is the core inverse relationship between rates and bond prices.
Duration measures sensitivity: a 10-year bond falls roughly 10% for every 1% rise in rates; a 2-year bond falls only about 2%. Longer maturity = higher interest rate risk.