Bonds, explained
A loan that you make, with a fixed coupon — and why its price falls when rates rise.
The anatomy
You buy a bond with a face value of €1,000 and a 4% coupon. The issuer pays you €40 a year and returns your €1,000 at maturity. Those numbers never change.
The issuer can be a government or a company. The greater the chance it fails to pay, the higher the coupon has to be to win you over.
That is why German bonds pay little while a small company's bonds pay a lot. That gap is called the credit spread, and it is the price of risk.
Why the price moves opposite to rates
You hold the bond with the 4% coupon. Tomorrow rates rise and new bonds pay 6%. Nobody will buy yours for €1,000, because they can get 6% elsewhere.
Your coupon cannot rise — it is fixed. So the only thing that can adjust is the price. It falls until €40 a year on the new price works out to about 6%.
That is the whole relationship, and it is mechanical, not psychological: rates up, bond prices down.
Duration: how far it falls
The further away the maturity, the more the price suffers when rates change. A two-year bond returns your money quickly; a thirty-year bond locks you into the old rate for thirty years.
That sensitivity is called duration. A duration of 8 means, roughly, that a 1% rise in rates cuts the price by 8%.
That is why in 2022 "safe" long-term bonds lost more than many shares. They did not fail; rates simply rose fast and the arithmetic did its work.
Rates rise 1% — what happens to the price
| Maturity | Approximate duration | Price drop |
|---|---|---|
| 2 years | 1.9 | −1.9% |
| 10 years | 8.5 | −8.5% |
| 30 years | 19 | −19% |
Key terms in this lesson
- Bond
- A tradeable loan with a fixed coupon and a fixed maturity date.
- Coupon
- The fixed annual interest payment on a bond.
- Yield
- The annual income from an asset, as a share of its current price.
- Duration
- How sensitively a bond's price reacts to a change in rates.
Quick check
You hold a 30-year bond and rates rise by 1%. Compared with a 2-year bond, what do you expect?
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