How a bond works
Every bond has four basic terms. The issuer is the borrower, such as the U.S. Treasury, a city or a company. The face value, or par, is the amount repaid at the end, often $1,000 per bond. The coupon rate is the yearly interest as a share of face value, so a 4% coupon on $1,000 pays $40 a year, usually as two $20 payments. The maturity date is when the face value comes back.
After it is issued, a bond trades between investors at a price quoted as a percentage of face value: 98.5 means $985 for a $1,000 bond. Current yield is the annual coupon divided by today’s price. Yield to maturity is the annual return if you buy at today’s price and hold to the end, counting the coupons plus the gain or loss as the price converges on par.
A bondholder is a lender, not an owner. You get only the promised interest and principal, with no share in the profits that holders of stock get, but the issuer is legally bound to pay.
Why bond prices fall when interest rates rise
A bond’s payments are fixed when it is issued, but market rates keep moving. If new bonds start paying more, nobody will pay full price for an older bond with a smaller coupon, so its price drops until its yield matches the market. When rates fall, older bonds with higher coupons gain value. The SEC compares this to a seesaw, and it applies to every fixed-rate bond, including those the U.S. government guarantees.
Longer maturities and lower coupons swing the most, one reason long-term bonds usually pay more. Duration, stated in years, measures that sensitivity: FINRA’s rule of thumb is that a bond’s price moves about 1% for each year of duration when rates change by 1 percentage point. Holders of long Treasury bonds felt this in 2026, as long-term yields climbed through the year.
If you hold an individual bond to maturity and the issuer pays, these swings never touch your cash flows. The price matters only if you sell early.
The main types of bonds
Treasury securities are backed by the full faith and credit of the U.S. government, so their default risk is the lowest in the market. They include short-term bills, notes of 2 to 10 years, 20- and 30-year bonds, and TIPS, whose principal rises with inflation. Municipal bonds are issued by states, cities and other public bodies, and their interest is usually free of federal income tax.
Corporate bonds carry the credit of the company that issues them. Bonds rated BBB (by S&P and Fitch) or Baa (by Moody’s) and above are investment grade; anything lower is high-yield, or junk, and pays more because default is more likely. Many corporate and municipal bonds are also callable, meaning the issuer can repay them before maturity.
Zero-coupon bonds, including Treasury STRIPS, pay no interest along the way; you buy them at a deep discount and collect face value at maturity. Savings bonds such as I bonds are government debt too, but they cannot be traded; you cash them in with the Treasury, and their value does not fall.
How to buy bonds: individual bonds or bond funds
New Treasuries are sold at auction through TreasuryDirect or a bank or broker, and electronic savings bonds only through TreasuryDirect. Corporate, municipal and older Treasury bonds trade through a brokerage account, where the dealer’s cost is built into the price: a markup when you buy and a markdown when you sell.
A bond mutual fund or ETF spreads credit risk across many issuers, trades easily and reinvests for you. But a typical fund never matures: it keeps buying new bonds, so its price never has to return to what you paid. The SEC warns that bond funds can lose money, even those holding only government or insured bonds.
An individual bond gives you known payments and a known end date, which is why people use them to match future bills or build a bond ladder. With corporate or municipal bonds, spread your money across enough issuers that one default cannot do serious damage.
The main risks of owning bonds
Bonds hold a place in most long-term asset allocations because high-quality ones swing far less than stocks and give retirees something to sell in a bad year for stocks, which limits sequence-of-returns risk. The research behind the 4% rule assumed a stock and bond mix: Bengen used intermediate-term Treasuries, and the Trinity study used long-term high-grade corporate bonds. How bonds compare with CDs and cash after tax is covered under fixed income.
Steadier is not the same as safe. Before you buy any bond, weigh these five risks, which apply in different degrees to the types above:
- Interest-rate risk: the price falls when market rates rise, most for long maturities and low coupons.
- Credit risk: the issuer may pay late or not at all, which is why lower-rated bonds pay more.
- Call risk: a callable bond can be repaid early, typically after rates fall, leaving you to reinvest at lower yields.
- Inflation risk: a fixed coupon buys less every year, which is why some investors hold TIPS alongside ordinary bonds.
- Reinvestment risk: coupons and maturing principal may have to be reinvested at lower rates than the bond paid.
Illustrative numbers
A 10-year, 4% bond when market rates move
- C
- Coupon payment per period (half the annual coupon for a semiannual bond)
- y
- Market yield per period for comparable bonds
- F
- Face value repaid at maturity
- n
- Number of payment periods left (twice the years for semiannual bonds)
The price is the present value of the remaining payments, so a higher market yield means a lower price.
Bond terms$1,000 face, 4% coupon, $20 every six months for 10 years
Price if comparable yields stay at 4%$1,000.00
Price if yields rise to 5% right after you buy$922.05 (−7.8%)
Price if yields fall to 3% instead$1,085.84 (+8.6%)
Paid if you hold to maturity, either way$400 of interest plus $1,000 back
The payments never change; only the price another buyer would pay does. The bond’s duration of about 8.2 years predicted roughly an 8.2% move for a 1-point change in rates; the real drop is a bit smaller and the real gain a bit larger. At $922.05 its current yield is $40 ÷ $922.05, or 4.34%.
At a glance
Main kinds of bonds at a glance
| Type | Issuer and backing | Credit risk | Interest taxed by |
|---|---|---|---|
| Treasury bills, notes and bonds | U.S. Treasury; full faith and credit of the U.S. government | Lowest | Federal only |
| TIPS | U.S. Treasury; principal adjusted for inflation | Lowest | Federal only, including inflation adjustments |
| Municipal bonds | States, cities and other public bodies | Low to moderate | Usually not federal; often not the issuing state |
| Investment-grade corporate | Companies rated BBB/Baa or higher | Moderate | Federal and state |
| High-yield corporate | Companies rated below BBB/Baa | High | Federal and state |
| Savings bonds (I and EE) | U.S. Treasury; cannot be traded | Lowest | Federal only |
Put it in your plan
Bonds in MoneyWhatIf
In MoneyWhatIf, an investment account can hold a mix of stocks and bonds, and dated bond-allocation periods can change the bond share, for example 20% bonds while working and 40% after retirement. Each period can split the bond share among up to four types (taxable, Treasury, own-state municipal and national municipal), which set how the interest is taxed in a taxable account. All types use the plan’s bond return assumption, and in historical scenarios the bond portion follows bond history, not a quieter copy of stock returns.
Common questions
Bonds FAQs
What is the difference between stocks and bonds?
A stock is a share of ownership in a company; a bond is a loan to a company or government. Stockholders share in profits through dividends and price gains, with no promised return. Bondholders get set interest and their principal back at maturity, and are paid before shareholders if the issuer fails. High-quality bonds are steadier but usually return less over long periods, and their interest is taxed as ordinary income rather than at the lower rates for qualified dividends and long-term gains.
Can you lose money on bonds?
Yes. You lose money if you sell after rates have risen, if the issuer defaults, or if inflation outpaces your interest. Even a U.S. government guarantee covers timely interest and principal, not the market price if you sell early. Bond funds can lose value too, because they have no maturity date to pull the price back to par.
How is bond interest taxed?
Corporate bond interest is taxed as ordinary income by the federal government and most states. Treasury interest is federally taxable but exempt from state and local income taxes, and most municipal bond interest is free of federal tax. Zero-coupon bonds are generally taxed each year on interest you have not yet received. A bond bought below par in the market can create market discount, generally taxed as interest when you sell or it matures. Many investors keep taxable bonds in tax-deferred accounts, a choice called asset location.
What does a bond’s credit rating mean?
A credit rating is an agency’s opinion of how likely the issuer is to pay on time. Bonds rated BBB by S&P and Fitch, or Baa by Moody’s, and above are investment grade. Lower-rated bonds are high-yield or junk bonds: they pay more interest to compensate for a greater chance of default. Ratings can be cut after you buy, and a downgrade usually lowers the bond’s price.