Module 10 · Investing
Bonds: lending your money
How a bond works, why its price falls when interest rates rise, what credit ratings tell you, and why 2022 showed that bonds can lose money too.
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In this lesson
- Explain coupon, face value, maturity and yield, and calculate a bond's yearly interest
- Show with numbers that a bond's price moves opposite to market yields
- Interpret credit ratings and credit spreads, and tell government from corporate bonds
- Explain why bonds and bond funds can lose money, and what holding to maturity does
Rok, 40, buys a 10-year government bond for €100. A year later, new bonds pay more interest than his, and he sees his bond is worth only €94 if he sells. He thought bonds were “safe”. What went wrong, and did it?
A bond is a loan with a timetable
A is a loan you make to a government or a company. In return, the borrower pays you interest, called the , usually once a year, and repays the face value (the amount lent, often €100 or €1,000) on a set date, the .
A €5,000 bond with a 4% coupon and 10 years to maturity pays 4% × €5,000 = €200 a year, then returns the €5,000.
Price and yield move in opposite directions
The is your total yearly return if you buy at today’s price and hold to maturity. A bond’s coupon is fixed, but its market price changes with the yield that similar new bonds offer. When market yields rise, older bonds with lower coupons become less attractive, so their prices fall.
If Rok holds until maturity and the borrower pays, he gets his €100 back, whatever happened in between. The loss is real only if he sells at €94, or if the borrower fails to pay.
Who borrows: credit ratings
Borrowers differ in how likely they are to repay. A is an agency’s grade of that likelihood. Ratings of BBB− or better (in S&P and Fitch’s scale) are called investment grade. Lower grades, such as BB, are “high yield” or “junk”. The riskier the borrower, the more yield it must offer. The extra yield over a safe government bond is the credit spread.
Governments that borrow in their own currency rarely default, but it has happened: Russia in 1998 and Argentina several times, and Greece restructured its debt in 2012. Inflation-linked bonds raise their principal with inflation, protecting real value.
2022: bonds can lose money
When interest rates rose fast in 2022, US 10-year government bonds lost about 17.8%, and US shares lost about 18%. Both fell together, the worst year for bonds in modern memory.
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