Bond Fundamentals: What a Bond Is, Bond Types, and Ratings

Up to now this course has been about owning things. A dividend stock makes you a part-owner of a business, and your income depends on that business deciding, quarter after quarter, to keep paying you.

Bonds work the other way. You're not an owner — you're a lender. Nobody decides each quarter whether to pay you; they owe you, by contract, on a schedule. That single difference changes everything about what bonds do in an income portfolio, what can go wrong, and how you judge one. This unit is about bonds, and it starts here, with what a bond is and the one piece of bond arithmetic that trips up nearly everyone.

What a bond actually is

A bond is a loan you make to a government or a company. That's it. Strip away the terminology and you have a very old arrangement: someone needs money now, you have money now, and they'll pay you for the use of it.

Both sides get something real. The issuer — whoever borrowed the money and owes you — gets cash today to build a road, expand a factory, or cover this year's operating costs, without giving up any ownership. You get interest payments on a fixed schedule, and your money back on a date you knew before you handed it over.

Notice what you don't get. No share of profits. No vote. If the company you lent to doubles its earnings, your payments don't change by a cent. Your upside is written into the contract, and the contract doesn't get more generous because things went well. In exchange, you stand ahead of the owners: they get paid after you do, not before.

The four numbers that define a bond

Every conventional bond comes down to four things. Learn these and any bond listing becomes readable.

The issuer is who owes you. This is the entire credit question — a bond is only as good as whoever has to pay it.

The par value is the amount you get back at the end. It's usually $1,000 per bond, and you'll also see it called face value. This number does not move. Ever. Whatever happens in the market between now and the end, par value is what the issuer owes on the maturity date.

The coupon is the interest rate the bond pays on its par value. A $1,000 bond with a 5% coupon pays $50 a year. Most bonds pay twice a year, so that's two payments of $25. (5% is an illustration, chosen because the arithmetic is easy to follow — not a current rate.)

The maturity is the date the issuer repays par value. Maturities run from a few weeks to thirty years, and some go longer. Short maturities are for borrowing that covers this year. Long ones are for building something meant to last.

Figure

Because par value comes back at maturity, bonds do something stocks structurally cannot: they hand your principal back on a known date. That's the reason they anchor an income portfolio. It holds as long as the issuer pays — which is not a footnote, and we'll come back to it.

Price is not par value

Here's the first place people get tangled, and it's worth pinning down before anything else.

A bond doesn't stay with its first buyer. It gets sold, and resold, sometimes many times before it matures. That trading happens on the secondary market — the market where investments are traded between investors rather than bought from the issuer. Almost certainly, any bond you buy comes from another investor, not from the government or company that issued it.

Which means a bond has two different dollar amounts attached to it, and they are not the same thing:

• Par value is fixed. $1,000 at maturity, always.
• Price is whatever someone will pay for it today. It moves.

You can pay $960 for a bond that repays $1,000. You can pay $1,040 for a bond that repays $1,000. A bond trading below par is at a discount; above par, at a premium. Neither one changes the $1,000.

Hold that separation in your head. The next section is built entirely on it.

Who issues bonds

Bonds are sorted by who's on the hook. Three issuer types cover nearly everything you'll encounter.

Treasuries. A Treasury is a bond issued by the U.S. government, to fund federal operations and public services. Interest and principal are backed by the full faith and credit of the U.S. government, which is the lowest credit risk — the risk the issuer doesn't pay you back — available anywhere in the market. That's priced in, so Treasuries generally pay less than the alternatives. Their low credit risk also makes them the yardstick: other bonds get measured against what a Treasury of the same maturity pays. Treasuries come in several forms, sorted by how long you're lending. Bills are the short end, running from four weeks out to fifty-two weeks. Notes occupy the middle, issued in two-, three-, five-, seven-, and ten-year maturities. Bonds are the long end, at twenty and thirty years. Alongside those sit two variants that break the fixed-payment mold: floating rate notes, issued at two years, whose interest payment resets rather than staying fixed, and Treasury Inflation-Protected Securities (TIPS), issued at five, ten, and thirty years, whose principal adjusts with inflation. The Treasury publishes all of this itself, at treasurydirect.gov, and sells these securities to the public directly.

Low credit risk is not the same as no risk, and this is where the source material most of the industry uses gets sloppy. A Treasury still carries interest-rate risk: its price falls when rates rise, exactly like any other bond. It still carries inflation risk: the fixed dollars it pays you buy less every year that prices rise. What's negligible is the chance you don't get paid. That's one risk out of three, and it's the only one anyone means when they call a Treasury safe.

Municipal bonds. A municipal bond is issued by a state, city, or local government — munis, for short. They fund state operations and local projects: a school, a bridge, a water system. Munis split into two kinds, and the difference is what's actually backing your money. A general obligation bond is backed by the issuer's full faith and credit, including its power to tax. A revenue bond is backed by one specific stream of money — a city builds a stadium, then pays you out of what the stadium collects. If that revenue stream disappoints, a general obligation bond has a whole tax base behind it and a revenue bond has a quiet stadium.

The other muni feature is tax treatment, and it's the reason muni yields look unimpressive until you do the comparison properly. Muni interest often gets favorable tax handling, which means a muni paying less than a corporate bond can still leave you with more. How much better depends on rules that operate at three levels at once — federal, your state, and sometimes your city — and the details turn on where the bond was issued and where you live. Check the current rules at IRS.gov and with your own state's tax authority before you price the benefit; don't assume it. Three things are worth knowing regardless. The benefit scales with your tax rate, so it's worth more to some people than to others. It's worth roughly nothing inside a 401(k) or IRA, where you already aren't paying tax on the interest. And the only honest comparison is after tax: work out what each bond leaves in your hand, because the yields on the screen aren't measuring the same thing.

Corporate bonds. Debt issued by companies, to fund projects and expansion. Companies can fail in ways governments generally don't, so corporates pay more. They're sorted less by purpose than by quality — which is the next section. Corporate debt maturing in under a year has its own name: commercial paper.

The usual ordering is government, then municipal, then corporate, from least risky to most. Treat that as a rough map, not a ranking. A well-run company can be a better credit than a city in trouble, and it happens often enough that the ordering is a starting point rather than an answer.

Credit ratings are opinions, not guarantees

You can't personally audit a state's finances or a company's balance sheet before buying its bond. So an industry exists to do it for you. A credit rating is an agency's opinion of an issuer's ability to repay — a letter grade estimating how likely you are to get your money.

A small number of recognized agencies dominate this work. Each uses its own letter scale and its own methods, so the same bond can carry two or three different-looking grades at once — which is why a quote often shows you more than one. The scales don't match each other letter for letter, and you shouldn't assume they do.

What they share is a shape. Each runs from a top grade for the strongest issuers down through several tiers to the bottom, where an issuer is already failing to pay. And each draws a line somewhere in the middle. Above that line is investment grade — higher-rated bonds, seen as lower credit risk. Below it is everything else. Every agency publishes its own scale and states plainly where its cutoff falls, so look it up on the agency's own site rather than trusting a letter you half-remember.

That line is the part worth your attention, more than any individual letter. It isn't just a description — it's a switch. Many funds, pensions, and institutions are bound by mandates that let them hold only investment-grade paper, so a bond crossing the line downward can force a wave of selling by people who have no choice in the matter and no opinion about the issuer. The letters are a summary. The line has consequences.

Figure

Below the line is the high-yield bond — a lower-rated bond that pays more to compensate for higher credit risk. You'll hear them called junk bonds, and we don't use that phrase without saying what it means, because the nickname makes people hear either "trash" or "bargain" and it's neither. Here's the honest version: a high-yield bond pays you more precisely because it might not pay you back. The extra yield is not a bonus for being clever. It's the price the market charges for a risk that is genuinely there. Sometimes that price is worth taking. It is never free.

Now the part that matters more than the letters.

A rating is an opinion. Not a measurement, not a promise, not a fact about the future. It's a professional judgment about a thing nobody can know — whether a borrower will still be able to pay you in ten years. Ratings change: an issuer gets downgraded, and the bond's price drops on the news even though every payment has arrived on time so far.

And consider who pays for the opinion. In the standard arrangement, the issuer selling the bond pays the agency to rate it. Read that again. The party that benefits from a high grade is the party writing the check. Nobody has to be corrupt for that to bend outcomes — incentives shape judgment quietly, in the close calls, over years. Agencies have been badly wrong before, at scale, on whole categories of bonds at once, and investors who treated the letter as a fact rather than an opinion found out the hard way.

Why your bond loses value when rates rise

This is the idea the whole lesson has been building toward, and it's the one beginners find genuinely strange. Rates go up, and your bond is suddenly worth less. But the issuer still owes you exactly what it always owed you. Nothing about your bond changed. So where did the money go?

Video coming soon

This lesson explains the idea in full without it.

Work it with numbers and it stops being mysterious.

You own a bond with $1,000 par, a 5% coupon, and one year left to run. (Round illustrative numbers; one year keeps the arithmetic exact and visible.) Over that year the bond pays you $50 in interest and then $1,000 of par. Total: $1,050, on a known date, from a borrower who is going to pay.

You want to sell it. What will someone give you?

Whatever they'd need to pay to get $1,050 elsewhere. That's the entire calculation. A buyer isn't valuing your bond in the abstract — they're comparing it to what else they could do with the same money right now. If new one-year bonds of the same quality pay 6%, the buyer will only put in an amount that grows to $1,050 at 6%. So:

Price = $1,050 ÷ (1 + the rate on new bonds)

Run it across a range and watch what happens.

Read the table from the middle outward, because both directions are the lesson.

Go down the table. Rates rise, and your price falls. At 10%, a buyer hands you $954.55 for a bond that will pay them $1,050 — and they're right to insist, because $954.55 invested at today's 10% gets them $1,050 anyway. Your bond is a worse deal than what's on the shelf, so it sells at a discount, and the discount is exactly the size that erases the disadvantage.

Go up the table. Rates fall, and your price rises. At 2%, your 5% bond is now the best thing available, and buyers compete for it. They'll pay $1,029.41 — more than par — for the privilege of a payment stream nobody can get by buying new. Same bond. Same issuer. Same $1,050.

That's the price-yield relationship: when bond prices rise, yields fall, and when bond prices fall, yields rise. It's not a market mood or a rule someone made up. It's arithmetic, and it runs in both directions with equal force.

Here's the sentence to keep. Your bond didn't get worse. A better alternative appeared. The issuer's obligation to you is untouched, your coupon still arrives, and par value still shows up at maturity. What fell is only the price someone else will pay to step into your shoes — and it fell because they now have somewhere better to stand.

One extension, and then we'll leave it: the effect isn't equal across bonds. A bond with one year left, like the one above, moves a little. A bond with twenty-five years left is locking its buyer into an off-market rate for twenty-five years, so the price has to move much further to compensate. Longer bonds swing harder when rates move. Same arithmetic, more years of it.

The number that already accounts for all of this

If the price you pay changes what you actually earn, then the coupon rate stops being a useful description of your return. A 5% coupon bought at a discount earns you more than 5%. Bought at a premium, less.

So investors buying on the secondary market look at yield to maturity (YTM) instead — what a bond actually returns if you buy it at today's price and hold it until maturity. It folds together the coupon payments still coming, the number of them left, and the gap between today's price and par value. It's the honest comparison number, and it's the one that lets you line up two bonds with different coupons and different prices and see which is really paying more.

The yield on a bond and its price are two views of the same fact. When you hear that yields rose, prices fell. When you hear that prices rose, yields fell. You never need to track both.

What else moves a bond's price

Interest rates dominate, but they aren't alone. A credit rating change moves a bond's price, in either direction — a downgrade means the market wants more compensation to hold the same paper, and an upgrade means it'll accept less. The economy moves prices, since a recession makes some borrowers look shakier while pushing rates around at the same time. And plain investor sentiment moves them: when people get frightened, they want the issuers they trust most, and they bid those up.

None of this is one-directional. Every one of these factors can help your bond's price or hurt it, and the same news does both to different bonds at once.

Key takeaways

• A bond is a loan, not ownership. Four things define it: the issuer who owes you, the par value you get back at maturity, the coupon rate it pays along the way, and the maturity date. Par value never moves. Price does.
• Bonds are sorted by issuer — Treasuries, municipal bonds, corporate bonds — running roughly from lowest credit risk to highest, and from lowest yield to highest. That ordering is a starting point, not a ranking; a strong company can be a better credit than a struggling city.
• A credit rating is an agency's opinion, not a guarantee — and the issuer being rated is the one paying for the rating. Investment grade sits above the line, high-yield bonds below it. A high-yield bond pays more because it might not pay you back. That's a price for risk, not a bonus.
• When interest rates rise, bond prices fall; when interest rates fall, bond prices rise. Your bond didn't change — a better or worse alternative appeared, and the price moved by exactly enough to close the gap. Longer maturities swing harder.
• Because price and yield move opposite each other, the coupon rate doesn't describe your return once you're buying on the secondary market. Yield to maturity does: what you earn if you buy at today's price and hold to the end.