Bond

Why bond matters

Bonds allow governments, companies, and other entities to finance spending while giving investors contractual cash flows. They can provide income, capital preservation, diversification, liability matching, or active exposure to rates and credit. The label covers instruments with very different risks. A short government bill and a subordinated corporate bond are both debt, but their sensitivity to rates, default, liquidity, and optionality differs materially.

How it is applied

Investors evaluate promised cash flows, price, yield, maturity, duration, credit quality, seniority, covenants, currency, liquidity, and embedded options. Present value is calculated by discounting coupons and principal at rates appropriate to timing and risk. Portfolio managers may hold individual bonds, funds, or derivatives and monitor exposures by issuer, sector, curve point, spread duration, and scenario. Settlement, accrued interest, and tax treatment also affect realized results.

Formula

Portfolio example

A five-year bond has $1,000 face value and pays a 4% annual coupon, or $40. If comparable required yield rises above 4%, investors will generally pay less than $1,000 because the fixed coupon is less attractive. If required yield falls, price generally rises. Credit deterioration can lower price even when government rates are unchanged, showing that several risks affect valuation simultaneously.

How to interpret it

Price and yield generally move inversely for a conventional fixed-rate bond. A bond trading below par may offer yield above its coupon, but the higher yield can reflect credit, liquidity, call, or other risk. Coupon is not total return: price change, reinvestment, default, currency, and costs matter. Maturity shows final contractual date, while duration provides a better first-order measure of rate sensitivity.

Limitations and common misconceptions

Promised payments are not guaranteed unless backed by a credible guarantor, and even government obligations carry inflation, rate, and currency risk. Yield measures rely on reinvestment and holding assumptions. Callable, convertible, floating-rate, and securitized bonds require additional models. Dealer liquidity can disappear during stress, while index prices may not be executable. Documentation, issuer analysis, scenario testing, and portfolio context are necessary beyond the bond label.