What Are Bonds? How Fixed Income Markets Work

A bond is a debt security through which an investor lends money to an issuer, typically in return for specified interest payments and repayment of principal under the bond’s terms. Governments, businesses and other organisations issue bonds to finance spending, investments or existing liabilities. The broader fixed income market includes bonds and related interest-bearing instruments, including instruments with floating or inflation-adjusted payments.

Although bonds are often associated with stable income, their prices can fluctuate substantially before maturity and some issuers may default. A bond’s coupon, yield, market price, maturity and credit quality describe different aspects of the instrument. Understanding those distinctions is the starting point for professional fixed income analysis.

What is a bond and how does it work?

A bond is a tradable claim created under legal documentation. The issuer receives financing and promises cash flows according to the terms of the security. For a conventional fixed-rate bullet bond, those cash flows are periodic interest coupons followed by the return of face value at maturity, provided the issuer performs its obligations. Other bonds may make no coupons, use floating rates, amortise principal or provide the issuer with a right to redeem early.

Suppose a fictional company issues a five-year bond with a face value of £1,000 and a fixed annual coupon rate of 4%. It promises £40 interest each year and £1,000 principal at maturity, assuming annual payment conventions. The coupon is determined by the original contract, but the bond’s current trading price can differ from £1,000 as market yields, credit risk and liquidity change.

The term fixed income should not be read as “fixed market value”. Even bonds promising fixed nominal cash payments are repriced continuously when investors change their required return. The bond can be worth less than its original purchase price if it must be sold before maturity.

Face value, coupon rate, maturity and market price

Face value, also called principal or par, is the contractual amount used for redemption and often for calculating coupons. Coupon rate defines promised interest relative to face value under a fixed-rate instrument. Maturity is when final principal is due unless the security has relevant earlier redemption or amortisation provisions. Market price is the amount a buyer and seller agree for the instrument at a particular time.

These terms are not interchangeable. A bond with a 2% annual coupon and £100 face value might trade at £90, £100 or £110, depending on the yield investors require and its specific cash flows. The £2 annual coupon does not change when the price moves, but the coupon’s ratio to the current price does.

Basic terminology for conventional bonds; specialised instruments may have different payment structures.

Who issues bonds?

National governments borrow through sovereign debt markets. The UK issues gilts; the US Treasury offers bills, notes, bonds, inflation-protected securities and floating-rate notes. Companies issue corporate bonds to finance acquisitions, operations and capital investment. Some subnational governments, agencies and public bodies borrow through other debt instruments.

A government’s debt issued in its own currency has a different risk profile from foreign-currency sovereign debt or a company’s unsecured borrowing. Nevertheless, even highly rated government bonds face interest-rate, inflation and market-price risk. Their repayment capacity, legal terms and currency matter. In some countries sovereign fiscal conditions can materially affect credit spreads.

See Government Bonds Explained for the distinctions between UK gilts and US Treasuries. The US SEC’s bond education guide provides a broad introduction to issuers and risks.

Government bonds versus corporate bonds

Government and corporate bonds both create creditor claims, but they differ in the source of repayment and the analysis needed. Government debt relies on the issuer’s fiscal capacity, monetary arrangements and institutions. Corporate bonds depend on a business’s earnings, cash generation, asset values, debt covenants and financing flexibility.

Corporate bonds can be issued as secured or unsecured debt and may be senior or subordinated in a group’s capital structure. Seniority affects contractual ranking, but does not promise full recovery following default. An investor must read the specific issue’s prospectus and indenture instead of assuming all securities of the same issuer have identical protection.

Corporate issues may include a call option permitting early repayment, floating coupons or other features that change how yields respond to interest rates. The credit-quality relationship is covered in Corporate Bond Credit Spreads and Default Risk.

What does it mean to own a bond rather than a share?

Shareholders generally hold a residual ownership interest and may participate in profits through dividends or changes in share price. Bondholders are creditors entitled to contractual cash flows subject to the terms and issuer’s ability to pay. Unlike ordinary equity, bonds do not normally provide a general share in unlimited future profits if the company grows unexpectedly.

In financial distress, creditors often rank ahead of ordinary shareholders, but different classes of debt have different priority and collateral rights. A secured lender can have a different recovery outcome from a subordinated bondholder. Bondholders still can lose most or all invested capital if obligations cannot be met and recoveries are inadequate.

For the equity side of the comparison see What Are Stocks and Shares?. Owning bonds does not remove business-specific risks; it changes the legal and economic claim.

Primary issuance and secondary-market trading

When a government or company issues new bonds, investors participate in the primary market according to the offering or auction rules. The issuer raises financing. Once issued, marketable bonds may trade among investors in the secondary market. Secondary-market purchases normally do not provide new financing to the original issuer.

The secondary bond market is often dealer-mediated. Some securities trade frequently with narrow spreads, while small corporate issues can be much less liquid. Prices may be quoted per £100 or $100 of face value, and the actual invoice can include accrued coupon interest. Trading conventions differ by market, and a displayed yield is not necessarily an executable quote for the required quantity.

Learn the mechanics in How Bond Markets Work.

Why do bond prices and interest rates move inversely?

A fixed-coupon bond promises specified nominal cash flows. When the yield required on comparable new securities rises, those cash flows become less valuable in present-value terms. Consequently, the existing bond’s market price generally falls. When the required yield declines, the existing cash flows usually become more valuable, raising price.

For a one-year bond paying £105 at maturity, its simplified value at a 5% annual yield is £105 ÷ 1.05 = £100. If the required yield rises to 7%, its value is £105 ÷ 1.07 ≈ £98.13. If the yield declines to 3%, value rises to approximately £101.94. The contractual £105 payment does not change; the discount rate does.

This mathematical relationship can become more complex for callable, floating-rate or credit-sensitive bonds. A yield rise may reflect higher government rates, widening credit spreads or a combination. See Bond Prices and Yields Explained.

Coupon, current yield and yield to maturity

The coupon rate is based on face value. Current yield commonly means annual coupon payment divided by the current bond price. Yield to maturity (YTM) is the discount rate equating the present value of contractual cash flows to the relevant market price, under assumptions about payment and redemption.

Suppose a £100-face bond pays £4 annually and is priced at £95, ignoring accrued interest for simplicity. The coupon rate is 4%, while current yield is £4 ÷ £95 ≈ 4.21%. YTM also reflects the £5 gain from redemption at £100 if held to maturity and paid as promised, so it differs from the current yield.

Neither current yield nor YTM guarantees realised returns. A seller before maturity faces price risk, while a holder may face default, early redemption or reinvestment differences. Always check the date, frequency and actual payment terms used for a quoted yield.

Duration: why maturity alone is insufficient

Interest-rate sensitivity depends on the timing and size of cash flows, not merely the final maturity date. Duration summarises aspects of that sensitivity. A long-maturity, low-coupon bond can respond more strongly to a yield shift than a shorter, higher-coupon bond. Modified duration is a first-order approximation for the proportional price change following a small parallel yield move.

For a hypothetical bond with modified duration of 7, a 0.50-percentage-point rise in yield corresponds to an approximate 7 × 0.005 = 3.5% price decline before convexity, carry, spread changes and costs. This is not a maximum loss and becomes less accurate for larger moves or bonds with embedded options.

For a fuller treatment see Bond Duration and Convexity Explained.

Credit risk and ratings

Credit risk is the possibility that a borrower does not meet payment obligations as promised or that its perceived capacity deteriorates. Credit ratings express agency opinions about relative credit quality, not assurances of repayment or investment suitability. Analysts distinguish investment-grade from speculative-grade ratings, but both categories can suffer price losses.

Two corporate bonds with similar cash-flow schedules can trade at different yields because investors require different compensation for perceived default risk, liquidity and other factors. The yield difference above a relevant benchmark is often discussed as a credit spread, though calculations require consistent maturity and curve conventions.

Read original issuer accounts, debt terms and maturity schedules instead of relying solely on ratings. A rating agency may respond after market prices have already adjusted. Strong credit analysis examines sustainable cash flow, funding, debt ranking and what happens under adverse conditions.

Inflation and purchasing-power risk

Even if a fixed coupon is paid exactly on time, inflation can reduce the real purchasing power of the money received. A nominal bond returning 4% when consumer prices rise 6% delivers a negative purchasing-power outcome under a simple inflation comparison. The exact real gross return is (1.04 ÷ 1.06) − 1 ≈ −1.89%.

Inflation-linked government securities change specified cash flows based on a defined price index, but their prices still react to real yields, liquidity and indexation details. US TIPS and UK index-linked gilts use different inflation indices and contractual provisions. For the full comparison see Inflation-Linked Bonds Explained.

Call risk and reinvestment risk

Some issuers have contractual rights to redeem bonds before their final stated maturity. A borrower may call an expensive high-coupon bond after market rates decline, subject to the permitted dates and call price. The bondholder receives contractual redemption proceeds but may have to reinvest at a less attractive rate.

The SEC’s explanation of callable bonds highlights this reinvestment risk. A bond promising 6% coupons for ten years does not necessarily deliver ten full years of coupon payments when the issue can be redeemed earlier under its terms.

Holding to maturity: what it does and does not guarantee

For a fixed-rate bond redeemed as promised, holding to maturity reduces the need to sell at an uncertain interim market price. But the contractual principal repayment is conditional on the issuer’s ability and legal obligation to pay. Holding does not remove inflation, reinvestment or opportunity cost. Callable and amortising bonds also may change the timing of principal receipts.

A bond purchased above par can redeem at a price below the amount paid. For example, paying £108 for a £100-face bond means the £100 maturity repayment is £8 below the original clean purchase price, offset to varying degrees by coupons received. Buying above face value is not automatically a mistake; the total yield calculation accounts for all cash flows.

Individual bonds versus bond funds

An individual fixed-rate bond has defined payment and maturity terms. A conventional open-ended bond fund or ETF typically holds many securities, trades or reinvests according to its mandate, and does not promise a fixed redemption value for each fund share at a particular date. Bond funds can diversify credit issuers but remain exposed to interest rates, credit spreads and changes in net asset value.

See Individual Bonds vs Bond Funds and ETFs for the practical differences. An investor should not assume that a bond fund’s distribution yield is a guaranteed total return.

How to begin analysing a bond

1. Identify the legal issuer, currency, security identifier and full contractual documentation.
2. Record face value, coupon convention, payment schedule, maturity and potential calls.
3. Check the quoted price basis, accrued interest and transaction costs.
4. Calculate or verify current yield, YTM, duration and relevant spread measures.
5. Assess issuer credit capacity, debt ranking, security and covenants where applicable.
6. Consider inflation, currency, reinvestment and liquidity under alternative outcomes.
7. Match the actual instrument to the objective rather than infer suitability from its yield alone.

How bond borrowing appears on an issuer’s balance sheet

Issuing debt increases an entity’s financing liabilities and generally provides cash proceeds, subject to issuance costs and accounting adjustments. Paying interest consumes cash while repayment of principal reduces the outstanding debt obligation. For a corporate borrower, accounting profit alone does not ensure that enough cash will be available when a large bond matures. Operating cash generation, capital spending and the timing of other obligations matter.

Consider an invented company that raises £100m through debt to build a distribution centre. The company receives funds but must still meet the bond’s coupon and eventual principal payments, regardless of whether the project succeeds. If the centre produces less cash than forecast, the company may need to use other cash flows, sell assets or refinance. A share issue would create a different ownership and financing structure, so neither choice can be assessed solely on the initial cash raised.

Why a bond’s yield is not the issuer’s profit

A bondholder’s promised interest is an expense or financing obligation for the issuer, not a share of the issuer’s profits. A company whose earnings double does not normally double the coupon on an existing fixed-rate bond. Instead, the issuer’s stronger finances may reduce perceived default risk, pushing its traded bond price higher and required yield lower. The bondholder’s maximum contractual receipts remain defined by the issue terms, barring particular contingent payment structures.

Conversely, when earnings weaken, the coupon can remain legally due even as the company’s ability to pay deteriorates. This asymmetry explains why equity and credit analysts may respond differently to the same business event. Shareholders focus heavily on the growth of residual profits; creditors focus on debt service and recovery protection.

For careful research, separate contractual return, credit protection and the market’s price. A bond with a high coupon can have an unattractive yield if it trades far above par, and a bond with a low coupon can have a high quoted yield when its price has fallen because of distress.

Frequently asked questions

Are bonds safer than shares?

Some bonds have lower historical volatility or higher contractual priority than ordinary shares, but safety depends on issuer, duration, currency, seniority and market conditions. High-yield and long-duration debt can suffer substantial losses.

Does a fixed coupon mean a fixed investment return?

No. The coupon can be fixed while the market purchase price and potential sale proceeds vary. Default, calls, inflation and reinvestment also affect realised return.

Can bondholders lose money if they hold to maturity?

Yes. Default or restructuring may impair payments, while inflation can reduce purchasing power. A purchase above par and the actual coupons also determine the overall nominal outcome.

Is a higher yield always more attractive?

No. Higher yield may compensate for greater duration, credit risk, call features, illiquidity or other disadvantages.

What is a gilt?

A gilt is a UK government debt security. Conventional gilts have fixed nominal coupon and principal obligations; index-linked gilts tie payments to specified inflation-indexation rules.

Key takeaways

Bonds are contractual debt claims that differ from shares in both legal rights and cash-flow structure. Their prices depend on yields, creditworthiness, expected inflation, liquidity and contractual features. Meaningful bond analysis goes beyond coupon rate to examine maturity, duration, spread, payment ranking and the conditions in which the issuer may fail to pay.

Continue learning about bond markets

For the central calculations see bond prices and yields. Explore the yield curve, bond funds versus individual securities, and the six-pillar fixed income research process.

Sources and further reading

• US SEC Investor.gov — Bonds Explained.
• UK Debt Management Office — About Gilts.
• US Treasury — Types of Marketable Securities.
• SEC — Callable Bonds.

Further structured learning: Explore the Professional Multi-Asset Trader Programme for more systematic education in bonds, yields, macroeconomic forces and fixed-income risk. This course provides education, not trading signals or personalised financial advice.

Important notice: This article is general financial education, not personal investment advice, a product recommendation or a forecast. All numerical examples are hypothetical, and bonds can lose value through changes in yields, credit risk, liquidity or currency exposures.