Bonds: Income, Duration, and Credit Risk
In brief
Learn how bonds work and why their prices can change even when payments are described as fixed income.
- Published
- Last reviewed
The main idea
A bond is a loan with interest-rate, credit, inflation, liquidity, and reinvestment risks.
What you’ll learn
- Separate coupon, yield, maturity, duration, and credit risk.
- Explain why bond prices change.
- Distinguish an individual bond’s maturity from a bond fund.
The basic contract
A bond issuer borrows money and promises specified payments under stated terms. The maturity date, coupon, seniority, and issuer’s creditworthiness help define the investment.
Sources: SEC Investor.govSEC Investor.gov
Why prices move
Existing bond prices generally respond to changes in market interest rates and perceptions of credit risk. Longer duration usually means greater price sensitivity to rate changes.
A bond fund does not mature as a single individual bond does. It continually holds a portfolio whose composition and duration may change.
Sources: SEC Investor.govSEC Investor.gov
Yield is not the whole story
A higher yield may compensate for greater credit, duration, liquidity, or structural risk. Compare securities on more than the income they advertise.
Sources: SEC Investor.govSEC Investor.gov
Yield is compensation, not free income
A quoted yield can reflect prevailing rates plus compensation for credit, liquidity, call, currency, or structural risk. Compare yield to maturity assumptions, issuer quality, seniority, call provisions, and expected holding period.
When market yields rise, existing fixed payments become less attractive and bond prices generally fall. Duration estimates sensitivity to yield changes; it is not the same as maturity, though the measures are related.
Supporting sources: SEC Investor.govSEC Investor.govAswath Damodaran, NYU Stern
Know what can happen before maturity
An individual bond held to maturity may return principal if the issuer pays as promised, but its market value can fluctuate and default remains possible. Selling early exposes the investor to the current market price.
A bond fund continuously owns many bonds and has no single maturity at which the investor’s original principal is promised back. Its diversification, reinvestment, expenses, and target duration should be evaluated as a portfolio.
Supporting sources: SEC Investor.govSEC Investor.govAswath Damodaran, NYU Stern
Evidence from the record
Bond returns are not coupon rates
NYU Stern’s methodology states that its 10-year Treasury bond return includes coupon income and price appreciation, so it does not equal the quoted Treasury yield for that year.
How to read it: Historical bond performance must be read as total return. A yield is an input, not a complete record of what a tradable bond earned.
View source: Aswath Damodaran, NYU Stern ↗Worked example
Explain a bond fund loss without calling it broken
Market yields rise and a high-quality bond fund reports a negative return.
- 1Recognize that existing bond prices generally fall when yields rise.
- 2Check the fund’s duration to understand rate sensitivity.
- 3Review whether credit quality changed.
- 4Consider that future reinvestment can occur at higher yields.
A short-term price loss can coexist with high-quality holdings. Rate risk and credit risk are different.
Common mistakes
- Comparing bonds only by yield.
- Calling a bond fund cash.
- Assuming government bonds cannot lose market value.
Put it into practice
- 1.Find a bond fund’s SEC yield, duration, and credit breakdown.
- 2.Explain each measure in plain language.
- 3.Write whether the holding is for income, stability, or a dated liability.
Educational context
This guide provides general education, not individualized investment, legal, or tax advice. Historical observations are labeled and linked to their source; they do not predict future results. Product rules and tax treatment can change, so verify current information with the relevant regulator, plan provider, or qualified professional.