Bonds and bond yields

In simple terms

A bond is a loan you can buy and sell. The borrower, a government or a company, promises to pay a fixed interest amount, the coupon, each year and to repay the face value on the maturity date. The equity and fixed income lesson introduced bonds; this lesson shows how their prices and yields work.

The key idea: a bond's payments are fixed, but the return investors demand changes with market interest rates. The price adjusts to bridge the gap.

Pricing a bond

A bond's price is the present value of its remaining payments, each discounted at the market yield, using the same compounding as the compounding lesson.

This is why bond prices and yields always move in opposite directions.

Coupon, current yield and yield to maturity

• Coupon rate: the coupon as a share of face value. Fixed at issue: 7% in the example.
• Current yield: the coupon divided by today's price. At ₹960, that is 70 ÷ 960, about 7.3%.
• Yield to maturity (YTM): the total yearly return from buying at today's price and holding to maturity, including the coupons and the gain or loss when face value is repaid, assuming every payment is made. At ₹960, the YTM is about 8%.

The coupon is the return only if you buy at face value and hold to maturity. Buy at ₹960 and you earn more; buy at ₹1,042 and you earn less.

Duration: how sensitive is the price?

Longer bonds are more sensitive to yield changes, because more of their payments lie far in the future. Duration puts a number on this sensitivity. A handy rule:

Percentage change in price ≈ −duration × change in yield (in percentage points)

The rule is an approximation that works best for small changes. For investors, the message is simple: the longer the bond or bond fund, the bigger the swings when rates move, as the interest-rate risk entry explains. A debt fund's factsheet usually reports its duration.

Government and corporate bonds

• Government bonds carry very low risk of default in their own currency, so their yields act as the base for other rates. Their yields reflect expected policy rates, inflation and the supply of government borrowing, as the fiscal policy lesson explains.
• Corporate bonds carry the risk that the company cannot pay. They yield more than government bonds of similar maturity. The difference is the credit spread, which widens when investors worry about defaults and narrows when they are confident. Credit ratings give an opinion of default risk, but ratings can be wrong or change suddenly.

Why bond yields matter for shares

Government bond yields are the "risk-free" benchmark investors use when valuing everything else. When yields rise, the return required from shares rises too, which tends to lower valuations, as the interest rates lesson shows. Bond markets are also where expectations about inflation and policy show up first.

Why it matters

Bonds and debt funds are a core part of most portfolios, and bond yields influence loan rates, company borrowing costs and share valuations. Understanding prices, yields and duration explains why "safe" debt funds can lose money when rates rise, and why bond markets react so quickly to inflation and policy news.

Limitations

The examples assume yearly coupons and no default; real bonds may pay twice a year, and some have special features such as call options or floating coupons. Yield to maturity assumes coupons are reinvested at the same yield. Duration is an approximation.

Common mistakes

• Treating the coupon rate as the return regardless of price.
• Forgetting that bond prices fall when yields rise.
• Ignoring duration when choosing a debt fund.
• Chasing the highest yield without asking why it is high.

Try it yourself

1. Price a ₹1,000, 3-year bond with an 8% coupon at market yields of 7%, 8% and 9%.
2. Find a debt fund's factsheet and note its average maturity, duration and yield.
3. Estimate how much that fund might lose if yields rose 1 percentage point.