Bonds are often described as the steadier part of a portfolio, but they still carry risks that are worth understanding. A bond is a loan: you lend money to a government, agency or company, and in return the issuer typically pays interest on a schedule and repays the face value at maturity. Three ideas explain most of how bonds behave: interest rates, duration and credit quality.
The basic parts of a bond
- Face (par) value: the amount the issuer promises to repay at maturity.
- Coupon: the interest rate the bond pays on its face value.
- Maturity: the date when the face value is due.
- Price and yield: after a bond is issued it trades in the market. Its price can be above or below face value, and its yield reflects the return you would earn based on the price you pay.
Why bond prices move opposite to interest rates
Imagine you own a bond paying a fixed coupon. If market interest rates rise, new bonds start paying more. Your older bond, with its lower coupon, becomes less attractive, so its market price falls until its yield is competitive. If rates fall, the opposite happens: your higher coupon becomes more valuable and the price rises. This inverse relationship is called interest rate risk. If you hold a high-quality bond to maturity, interim price changes matter less, because you expect to receive the face value back. They matter a great deal if you need to sell early or if you hold a bond fund, whose share price reflects current market prices.
Duration: measuring sensitivity to rates
Duration estimates how much a bond's price is likely to change when interest rates change. It is expressed in years, and the higher the duration, the more sensitive the price. Some general patterns:
- Longer maturities usually mean higher duration.
- Lower coupons usually mean higher duration, because more of the bond's value comes from the final repayment.
- Bond funds publish an average duration, which helps you compare their sensitivity to rate changes.
Duration is an estimate that works best for small rate changes, but it is a practical way to compare bonds and funds.
Credit quality: the risk of not being repaid
Credit risk is the chance that the issuer cannot make interest payments or repay principal. Credit rating agencies assign ratings that summarise their view of that risk. Bonds rated in the higher categories are called investment grade; those below are often called high-yield or speculative-grade bonds.
- Lower-rated issuers generally have to offer higher yields to attract investors.
- A downgrade can push a bond's price down even if interest rates are unchanged.
- U.S. Treasury securities are backed by the full faith and credit of the U.S. government and are generally treated as having very low credit risk, though they still carry interest rate risk.
Ratings are opinions, not guarantees, so it is worth reading how a bond or fund describes its credit risk.
How the three interact
A long-term, lower-rated bond carries both higher interest rate sensitivity and higher credit risk. A short-term, high-quality bond carries little of either, and usually yields less as a result. Many investors use a mix of maturities and credit qualities, or diversified bond funds, to balance yield against these risks.
Other risks to know
- Inflation risk: fixed payments buy less if prices rise. Treasury Inflation-Protected Securities (TIPS) are designed to adjust for inflation.
- Call risk: some bonds can be repaid early by the issuer, often when rates fall.
- Liquidity risk: some bonds trade infrequently and can be harder to sell at a fair price.
Key takeaways
- Bond prices move in the opposite direction to interest rates.
- Duration estimates how sensitive a bond or fund is to rate changes.
- Credit quality reflects the risk of default; lower quality usually means higher yield and higher risk.
- FINRA and Investor.gov offer free, detailed guides to bonds and bond funds.
This article is general educational information, not investment, tax or legal advice, and it does not recommend any specific security or strategy. Check current details on Investor.gov (SEC) or FINRA, and consider speaking with a qualified, registered professional about your own situation.