How Bonds Work: Yields, Prices, Interest Rates and Bond Types Explained

Bonds don’t get as much attention as stocks, but the global bond market is larger than the stock market. Governments and companies issue bonds to borrow money, and investors earn interest in return. Bonds are a core building block of many portfolios because they generate income and tend to be steadier than stocks.

This guide explains how bonds work, why their prices move, the main types and how to invest in them.

What is a bond?

A bond is a loan you make to an issuer — a government, municipality or corporation. In return, the issuer promises to:

• Pay you interest, called the coupon, at regular intervals
• Repay the face value (principal) at maturity

Key terms

• Face (par) value: The amount repaid at maturity, often $1,000 per bond.
• Coupon rate: The annual interest as a percentage of face value.
• Maturity: When the principal is repaid — from a few weeks to 30 years.
• Price: What the bond trades for in the market; it can be above or below par.
• Yield to maturity (YTM): Your total annual return if you buy at today’s price and hold to maturity.

Example: A 10-year bond with a $1,000 face value and a 5% coupon pays $50 a year (often as two $25 payments) and returns $1,000 at maturity.

The most important rule: rates and prices move in opposite directions

When market interest rates rise, existing bond prices fall; when rates fall, prices rise.

Why? If you own a bond paying 4% and new bonds pay 5%, no one will pay full price for yours. Its price must drop until its yield is competitive with new bonds.

Duration measures how sensitive a bond’s price is to rate changes. As a rough rule, a bond with a duration of 7 years will lose about 7% of its value if rates rise one percentage point — and gain about 7% if rates fall by one point. Longer-maturity bonds have higher duration and more price risk.

Key point: If you hold a high-quality bond to maturity, interim price swings don’t matter — you still receive all coupons and your principal. Price risk matters if you need to sell early.

Types of bonds

US Treasuries

Issued by the US government and considered among the safest investments in the world.

• Treasury bills (T-bills): Mature in one year or less; sold at a discount.
• Treasury notes: 2–10 years.
• Treasury bonds: 20–30 years.
• TIPS: Principal adjusts with inflation, protecting purchasing power.
• Series I Savings Bonds: Inflation-linked savings bonds with purchase limits.

Treasury interest is exempt from state and local income tax. You can follow the 10-year Treasury yield on our stock market page.

Municipal bonds

Issued by states and cities. Interest is often exempt from federal income tax, and sometimes state tax for residents, which can make them attractive for high earners.

Corporate bonds

Issued by companies. They pay higher yields than Treasuries to compensate for credit risk.

• Investment-grade: Rated BBB-/Baa3 or higher by agencies such as S&P, Moody’s and Fitch.
• High-yield (“junk”): Lower ratings, higher yields and higher default risk.

International and emerging-market bonds

Bonds from other governments and companies can add diversification but introduce currency and political risk.

Bond risks

1. Interest rate risk: Prices fall when rates rise.
2. Credit (default) risk: The issuer may fail to pay.
3. Inflation risk: Fixed payments lose purchasing power when inflation is high.
4. Reinvestment risk: When bonds mature, you may have to reinvest at lower rates.
5. Liquidity risk: Some bonds are hard to sell quickly at a fair price.
6. Call risk: Some bonds can be repaid early by the issuer, usually when rates fall.

How to invest in bonds

Individual bonds

You can buy Treasuries directly through TreasuryDirect or via a brokerage, along with corporate and municipal bonds. Holding individual bonds to maturity gives predictable cash flows. A bond ladder — bonds maturing at staggered dates — spreads interest-rate and reinvestment risk.

Bond funds and ETFs

Bond mutual funds and ETFs hold hundreds of bonds, providing instant diversification and easy trading. A total bond market index fund is a simple core holding. Unlike individual bonds, funds have no maturity date, so their value changes continuously with rates. Compare structures in our mutual funds vs ETFs guide.

Money market funds and CDs

For short-term savings, money market funds and CDs offer bond-like income with very low volatility. See APY vs APR.

The role of bonds in a portfolio

Bonds can:

• Reduce volatility compared with an all-stock portfolio
• Provide steady income
• Act as ballast in many stock market sell-offs (though not always — in 2022 stocks and bonds fell together)
• Match future spending needs, such as tuition or retirement withdrawals

The right stock-bond mix depends on your time horizon and risk tolerance. Our guide to asset allocation and diversification offers example portfolios.

Taxes

Interest from corporate bonds and most bond funds is taxed as ordinary income. Treasury interest is exempt from state and local tax, and municipal bond interest is often exempt from federal tax. Holding taxable bonds in tax-advantaged accounts such as IRAs can improve after-tax returns.

Conclusion

Bonds are loans that pay you interest. Understand the inverse relationship between rates and prices, match maturity to when you’ll need the money, weigh credit risk against yield, and choose between individual bonds and diversified funds. Used thoughtfully, bonds bring stability and income to almost any portfolio.