How bonds pay interest and why their prices move

When a city wants to build a new school, it may borrow the money by selling bonds. Each bond is a loan from the buyer to the issuer, backed by a written promise to pay interest for a set period and to repay the amount borrowed at the end. The issuer might be a national government, a state or city, or a company. That promise is what makes a bond's income more predictable than a share's dividend, although predictable does not mean guaranteed.

The second part of the story is price. Many people assume a bond is worth exactly what they paid until it matures, but bonds trade on the open market like other investments. A bond sold a year after purchase may bring in more or less than its original price. The reason usually traces back to the bond's fixed interest rate compared with what new bonds are paying, and to how much the market trusts the issuer to keep its promises.

Who issues bonds and what the buyer receives

Governments, municipalities and corporations all issue bonds, and each has different reasons for borrowing. Governments often borrow to cover spending that taxes do not fully pay for, while companies may borrow to finance expansion, equipment or the refinancing of older debt. From the buyer's side, the bond itself describes the terms: how much interest is paid, how often, and when the principal comes back. Those terms are set at issue and written in the bond's offering documents.

Most bonds are issued with a face value, also called par value, which is the amount the issuer repays at maturity. Many corporate bonds have a face value of 1,000 dollars, although the exact denomination varies by issue. Face value is the starting point for every calculation that follows, because the interest and the final repayment are both measured against it.

Coupons and the interest payments

The coupon rate is the fixed annual interest a bond pays, expressed as a percentage of face value. A bond with a 1,000 dollar face value and a 5 percent coupon pays 50 dollars a year. In the United States, coupons are often paid twice a year, so that bond would typically pay 25 dollars every six months. For a fixed-rate bond, the coupon is set when the bond is issued and does not change over its life.

This fixed schedule is why bonds are often used where steady cash flow matters. The holder knows the amount and timing of each payment in advance, provided the issuer makes them. Some bonds are sold at a discount or a premium to face value, which changes the total return even though the coupon itself stays the same. Keeping the coupon separate from the total return is one of the first habits that helps newcomers read bond listings correctly.

Maturity and getting principal back

Every bond has a maturity date, the point when the issuer repays face value and makes its final interest payment. Maturities can run from a few months to several decades. Short-term bonds return the principal sooner, which generally means less time for prices to move. Long-term bonds lock in a coupon for longer, which can help when rates fall and hurt when they rise, as the next sections explain.

Some bonds include features that change the schedule. A callable bond lets the issuer repay early, often after interest rates have fallen. The investor then gets the money back sooner and may have to reinvest it at lower rates. Check the bond's terms for call features before buying, because a bond that is repaid early can disappoint a buyer who paid a premium above face value.

Why prices move before maturity

Between issue and maturity, a bond's market price reflects what buyers and sellers are willing to pay. The two most important influences are changes in market interest rates and changes in how risky the issuer appears. When newly issued bonds pay higher coupons than an older bond, the older bond usually has to sell for less to offer a comparable return. When rates fall, the reverse tends to happen.

Buying between coupon dates adds a detail that often surprises newcomers. The buyer typically pays the seller the interest that has built up since the last payment, called accrued interest, and then receives the full coupon on the next payment date. The price quoted and the amount actually paid can therefore differ, so check the settlement amount before relying on any yield figure.

Yield is a separate measure. Current yield is the annual coupon divided by the market price. Yield to maturity estimates the annual return if you hold the bond until it matures, the issuer makes every payment on time and you reinvest each coupon at the same rate. Yield to maturity is a useful way to compare bonds, but it rests on assumptions that do not always hold in practice.

Credit risk and the issuer

Price movement is only one kind of risk. Credit risk is the chance that the issuer cannot make its payments. Bonds issued by national governments with strong finances are generally regarded as carrying very low credit risk, while bonds from companies and smaller issuers vary widely. Independent credit ratings give a general sense of this risk, but ratings can change and are not guarantees. A bond whose issuer loses the market's confidence can fall sharply in price, even before any payment is missed.

A common mistake is treating bond interest as free of risk because the payments are scheduled. A bond can pay its coupon on time for years and still lose value if rates rise or the issuer's finances weaken. Reading the offering documents, understanding the issuer and deciding how long you can hold the bond all make a bond's behavior easier to anticipate. The coupon is the promise, and the price is what the market thinks that promise is worth at any given moment. For decisions involving significant money, a licensed financial professional can help you weigh them against your own situation.