Definition
A bond is debt issued by a government or company. Its terms specify payment obligations, such as interest and repayment of principal. Those promises depend on the issuer meeting its obligations. A bond's face value can differ from the price an investor pays.
Four terms help distinguish the contract from the investment result:
- Par or face value: the stated principal amount. Denominations vary.
- Coupon: interest calculated under the bond's terms. Coupons may be fixed or floating; zero-coupon bonds make no periodic coupon payments.
- Maturity: when principal is scheduled to be repaid. Call or prepayment provisions can cause earlier repayment, and default can prevent full repayment.
- Yield: a calculation relating cash flows to price. The meaning depends on the measure and its assumptions; it is not a guarantee of the return you will realize.
See the SEC's corporate bond explanation.
Why It Matters
For a conventional fixed-rate bond, a higher required market yield means a lower price, all else equal. A bond bought above par can repay less principal than the purchase price even if the issuer meets every obligation. Coupon income must be considered with that premium or discount.
Bond portfolios can diversify stock exposure, but bonds and stocks can decline together. Credit quality, rate sensitivity, inflation, and the investor's time horizon all matter. A monthly bond-fund distribution can change and does not guarantee preservation of capital.
The Main Risks
Interest-rate risk: duration estimates price sensitivity to a small change in yields. A modified duration of six implies approximately a 6% price decline for a one-percentage-point yield increase, holding other factors constant. This is an approximation, not a forecast; convexity, cash-flow changes, and different yield-curve movements can change the result.
Credit and spread risk: default, rating changes, or a higher premium demanded for credit risk can lower prices. An investment-grade rating is not a guarantee. Treasury securities have different credit exposure from corporate debt, but Treasury funds can still lose value.
Liquidity, call, and reinvestment risk: selling may require accepting an unfavorable price. An issuer may repay early under the contract, and replacement investments may offer lower yields. Inflation can reduce the purchasing power of payments.
The SEC explains these risks in its bond fund guide.
Current Yield, YTM, and SEC Yield
| Measure | What it describes | Important limitation |
|---|---|---|
| Current yield | Annual coupon divided by current price | Omits price change and principal repayment |
| Yield to maturity (YTM) | Discount rate equating scheduled cash flows to price | Assumes scheduled payments; realized compound return also depends on reinvestment |
| Yield to call or worst | Yield under specified call or other repayment scenarios | Does not remove default risk |
| 30-day SEC yield | Standardized recent net fund income, annualized | A snapshot, not a future total-return promise |
Compare measures from the same reporting period. A portfolio's reported YTM and a fund's SEC yield are different statistics. Neither should be substituted for realized total return or compared blindly with a trailing distribution rate.
Example
Suppose a hypothetical bond has $1,000 face value and a fixed 5% annual coupon, and you buy it for $900. Annual coupon income is $50, so current yield is $50 / $900, or about 5.56%. If it pays as scheduled and repays $1,000 at maturity, there is also a $100 price gain. Calculating YTM requires the remaining maturity and payment schedule. Fees, taxes, default, early repayment, and reinvestment rates can change the realized result.
The reverse can happen with a premium purchase. Paying $1,100 for the same $1,000 face value does not oblige the issuer to repay $1,100. The coupon is only part of the outcome.
Individual Bonds and Bond ETFs
An individual bond has its own payment schedule and terms. A conventional bond ETF holds a portfolio that usually replaces maturing securities and has no fixed end date. Its market price and NAV fluctuate, and payments depend on portfolio income and costs. The number of holdings and distribution frequency vary by fund.
Target-maturity bond ETFs are an exception: they generally wind down around a specified year. Their final distribution depends on portfolio proceeds and expenses, not a guaranteed par value per ETF share. They should not be confused with target-date retirement funds, which change their asset mix over time.
For an illustration of this structure, see iShares iBonds ETFs.
Common Mistakes
- Treating par repayment as repayment of the exact purchase price.
- Assuming every bond pays a fixed coupon or every bond ETF continues indefinitely.
- Reading a high yield as free additional return rather than investigating its risks.
- Treating duration as an exact prediction or a Treasury fund as immune to price declines.
- Assuming holding to maturity removes default, inflation, or reinvestment risk.
FAQ
Can a bond ETF lose money?
Yes. Rate changes, credit losses, spreads, and trading conditions can reduce value. Distributions do not ensure a positive total return.
Does every bond ETF have no maturity date?
No. Conventional funds usually roll their portfolios, while target-maturity funds generally wind down around a specified year. Neither structure promises an ETF investor a fixed repayment of the original purchase price.
Is yield to maturity the return I will earn?
Not necessarily. It is a cash-flow calculation with assumptions. Defaults, calls, trading costs, taxes, and coupon reinvestment can change realized returns.
Are bonds guaranteed to rise when stocks fall?
No. Their relationship changes with economic conditions and holdings. Both can decline, particularly when inflation or rising yields weigh on multiple asset classes.
