Bonds and Fixed Income

Bonds are the stabilizers of a portfolio: less exciting than stocks, and that is exactly the point. This guide covers how bonds work, why prices move opposite to yields, duration, credit risk, every major bond type, and how to actually own them.

By Karanvir Singh, founder of Quantix Invest

What a bond is

A bond is a loan that you make. When a government or company needs money, it can borrow from investors by issuing bonds. Buy the bond and you become the lender. In exchange, the issuer promises two things:

• Interest payments (called coupons) on a fixed schedule, usually every six months for US bonds.
• Return of the principal (called face value or par value, typically $1,000 per bond) on a specific date, the maturity date.

That is the entire contract. Unlike a stockholder, a bondholder does not own a piece of the business and does not share in its upside. If the company doubles its profits, your coupon does not change. In exchange for giving up the upside, you get seniority: if the issuer runs into trouble, bondholders get paid before stockholders. Interest is a legal obligation; dividends are optional.

This makes bonds fundamentally different from stocks in character. A stock is a claim on an uncertain future. A high-quality bond is a schedule of known payments. Uncertainty still exists, but it comes from two specific, well-understood sources: interest rates and creditworthiness. Master those two ideas and you understand bonds.

Coupons, maturity, and yield

Three numbers define a basic bond:

• Face value (par): what you receive at maturity, standardly $1,000.
• Coupon rate: annual interest as a percentage of face value. A 4% coupon on a $1,000 bond pays $40 per year, usually as two $20 payments. The coupon is fixed at issuance and never changes.
• Maturity: when the principal comes back. Money-market instruments mature within a year; notes run roughly 2 to 10 years; long bonds run 20 to 30 years.

Here is the subtlety: after issuance, bonds trade in the market, and the price moves even though the coupon does not. So a bond has several "yields," and the differences matter:

• Coupon rate: fixed forever. $40 per year on our example bond, whatever the price.
• Current yield: annual coupon divided by today's price. If the bond trades at $950, current yield is 40 / 950 = 4.21%.
• Yield to maturity (YTM): the total annualized return you earn if you buy at today's price and hold to maturity, counting both the coupons and the gain or loss between today's price and the $1,000 you get back at the end. YTM is the number professionals mean when they say "yield," and it is the number to compare across bonds.

When a bond trades below face value ("at a discount"), its YTM is above its coupon rate, because you also earn the pull back up to par. Above face value ("at a premium"), YTM is below the coupon rate. At exactly par, they are equal.

Why prices fall when yields rise: a worked example

The most important mechanical fact in fixed income: bond prices and interest rates move in opposite directions. This is not a market quirk; it is arithmetic. Walk through it once and it becomes obvious.

Step 1. Last year you paid $1,000 for a 10-year Treasury note with a 3% coupon. It pays you $30 per year, then $1,000 back at maturity.

Step 2. Today, rates have risen. Newly issued 10-year Treasuries now carry a 5% coupon: $50 per year on the same $1,000.

Step 3. You want to sell your 3% bond. Who would pay $1,000 for $30 a year when $1,000 buys $50 a year from a brand-new bond of identical safety? Nobody. To find a buyer, your price must drop until your bond's yield to maturity matches the new 5% environment.

Step 4. How far must it drop? The price has to fall enough that the buyer's total return (the $30 coupons plus the gain from buying below $1,000 and receiving $1,000 at maturity) works out to 5% per year. For a bond with 9 years left, that price is roughly $858. The buyer collects $30 per year (a 3.5% current yield on their $858) plus a built-in $142 gain over 9 years, and the combination compounds to about 5% annually.

So a 2-percentage-point rise in rates knocked about 14% off the price of a completely safe bond. Nothing defaulted. The government will still pay every penny. The loss is real only if you sell; hold to maturity and you get exactly the 3% you signed up for, while suffering the quieter cost of earning 3% in a 5% world.

Run the film in reverse for the pleasant version: if new bonds yielded only 1%, your 3% bond would trade well above $1,000, because $30 a year is a prize in a 1% world.

Recent history made this vivid. In 2022, the Federal Reserve raised its policy rate at the fastest pace in four decades to fight inflation, and the broad US investment-grade bond index posted its worst calendar year in its modern history, a decline of roughly 13%. Investors who thought "bonds cannot lose money" learned the duration lesson painfully. The silver lining: after prices fell, yields were the highest in over a decade, meaning better expected returns for bond buyers from that point forward.

Duration and interest-rate risk

How much a bond's price moves when rates change depends mostly on how long its payments stretch into the future. The measure of that sensitivity is duration, quoted in years.

The working rule: for a 1-percentage-point change in interest rates, a bond's price moves approximately its duration in percent, in the opposite direction.

The approximation is good for small rate moves and gets rougher for big ones, but it is the single most useful risk number on any bond fund page.

Why would anyone hold long duration? Because it usually pays more yield (see the yield curve section), and because long bonds rally hardest when rates fall, which historically has often happened in recessions, exactly when stocks are falling. Long Treasuries are a potent but volatile diversifier; intermediate duration is the conventional middle ground for the bond portion of a retirement portfolio.

Credit risk and ratings

The second risk: the borrower might not pay. Credit rating agencies (Moody's, S&P Global, Fitch) grade issuers on the likelihood they will make good on their debts.

Riskier borrowers must offer higher yields to attract lenders. The extra yield over a Treasury of the same maturity is the credit spread. Spreads breathe with the economy: they compress when times are calm and blow out in recessions and panics, which means lower-rated bonds can fall hard exactly when stocks fall. Historical default studies from the rating agencies show investment-grade defaults are rare over any given decade, while cumulative default rates for low single-B and CCC issuers run far higher, especially across a recession.

Ratings are opinions, not guarantees, and the agencies' famous misses on highly rated mortgage securities before 2008 are a permanent reminder. But as a broad sorting of default risk, the scale works and everything in the bond market is priced off it.

The bond menu: Treasuries to high yield

US Treasuries. Debt of the US federal government: bills (up to 1 year), notes (2 to 10 years), bonds (20 to 30 years). Backed by the government's taxing power, they are the global benchmark for "risk-free" credit, which leaves interest-rate risk as their only meaningful risk. Interest is exempt from state and local income tax. Buyable commission-free at auction through TreasuryDirect or any major broker.

TIPS (Treasury Inflation-Protected Securities). Treasuries whose principal adjusts with the Consumer Price Index. The coupon rate is fixed but is paid on the inflation-adjusted principal, so both interest and final principal keep pace with measured inflation. TIPS quote a "real yield," a return above inflation. Tradeoffs: in taxable accounts the annual principal adjustments are taxed as income even though you have not received the cash (the "phantom income" issue, so TIPS fit best in tax-advantaged accounts), and TIPS still carry duration risk, as 2022 demonstrated when they fell alongside everything else despite high inflation.

Series I savings bonds. A savings product, not a marketable bond. The composite rate combines a fixed rate (set for the life of the bond) with an inflation rate that resets every six months. Principal never declines. Limits and rules as of 2026: $10,000 electronic purchase limit per person per year through TreasuryDirect, cannot redeem in the first 12 months, redeem before 5 years and you forfeit the last 3 months of interest, and federal tax is deferred until redemption (no state or local tax). Excellent for a slice of long-term emergency savings; the purchase cap keeps them from being a full portfolio solution.

Municipal bonds ("munis"). Issued by states, cities, and local agencies. Interest is generally exempt from federal income tax, and usually from state tax for in-state residents. Because of the tax break, munis carry lower stated yields, so they mainly make sense in taxable accounts for people in higher brackets. Compare them with the taxable-equivalent yield: muni yield divided by (1 minus your marginal tax rate). Worked example: a 3.0% muni for someone in the 32% federal bracket is equivalent to 3.0% / 0.68 = 4.41% taxable. If comparable taxable bonds pay less than that, the muni wins after tax. Defaults are historically rare for general-obligation and essential-service bonds, but not zero (Detroit and Puerto Rico are the modern cautionary tales), so diversified muni funds beat single-issuer bets for most people.

Investment-grade corporate bonds. Loans to solid companies. They yield more than Treasuries (the credit spread) and form a large chunk of the total bond market index alongside Treasuries and agency mortgage-backed securities. Their interest is fully taxable, which argues for holding them in retirement accounts when you have the choice.

High-yield ("junk") bonds. Loans to below-investment-grade companies. They pay meaningfully higher coupons, but they behave partly like stocks: in recessions, defaults rise and prices drop alongside equities. That correlation means high yield is a poor substitute for the safe-ballast role bonds usually play. Treat it, if at all, as a risk asset in the stock-like part of your allocation, in fund form only.

Bond funds vs individual bonds

You can lend directly (buy individual bonds) or pool (buy a bond fund holding thousands of them). For Treasuries, either works well. For corporates and munis, funds are the practical answer for nearly everyone.

The "predictability" row drives most of the debate. An individual Treasury held to maturity cannot hand you a nominal loss; a bond fund can be down when you need to sell. But the difference is smaller than it feels: a bond fund is essentially a bond ladder that constantly rolls itself, and if your holding period is at least as long as the fund's duration, rising rates hurt prices now but help through higher reinvested yields later, roughly washing out. The fund investor and the ladder investor own the same stuff.

Two clean use cases for individual bonds: a ladder of Treasuries or CDs timed to known expenses (tuition due in 2, 3, and 4 years, say), and TIPS ladders built to produce a known inflation-adjusted income floor in retirement. For the general "bond portion of my portfolio" job, a total bond market index fund is simpler and cheap.

The yield curve

Plot Treasury yields against maturities (3 months, 2 years, 10 years, 30 years) and you get the yield curve, one of the most watched pictures in finance.

• Normal (upward-sloping): long yields above short yields. Lenders demand extra for locking money up longer and bearing more rate risk. This is the usual state.
• Flat: little difference across maturities, common in transitions.
• Inverted: short yields above long yields. This happens when the Federal Reserve pushes short rates high (to fight inflation) while markets expect lower rates ahead. Inversions, especially in the 3-month vs 10-year comparison, have preceded most US recessions of the past several decades, which is why they make headlines. The signal is historically strong but not mechanical: the 2022 to 2024 inversion, one of the longest on record, was not followed by the prompt recession many predicted, a live reminder that famous indicators are probabilistic, not prophetic.

For a long-term investor, the curve's practical use is modest: it shows what you are paid for extending maturity. If 10-year bonds yield little more than 1-year bills, extending duration buys little income and much risk; when the curve is steep, extending pays.

CDs and money market funds

The short end of fixed income is where safety is nearly absolute and the job is capital preservation.

Certificates of deposit (CDs). A bank time deposit: a fixed rate for a fixed term (3 months to 5+ years), with FDIC insurance up to $250,000 per depositor, per bank, per ownership category. Withdraw early and you typically forfeit a few months of interest. Brokered CDs, bought through a brokerage, let you shop many banks at once and can be sold on a secondary market (at market price) instead of paying a penalty. Great for known near-term expenses; compare their after-tax yield against Treasuries of the same maturity, since Treasury interest skips state tax and CD interest does not.

Money market funds. Mutual funds holding very short, high-quality paper (T-bills, repurchase agreements, top-tier corporate paper), managed to keep a stable $1.00 share price. Yields float daily with short-term rates: near zero in the early 2020s, then above 5% at the 2023 to 2024 peak after the Fed's hiking cycle, and lower as rates came down from there. They are not FDIC-insured, though government money market funds holding Treasuries and government-backed paper are considered extremely safe; "breaking the buck" has happened only in rare crises. Government money funds also pass through partial state-tax exemption on their Treasury interest.

Cash-like instruments look wonderful when short rates are high, and every such period tempts investors to hold cash instead of bonds or stocks. The catch is reinvestment risk: cash yields evaporate the moment the Fed cuts, while a bond locks its yield for years and gains price when rates fall. Cash is for spending needs and emergencies, not a long-term strategy.

The role of bonds in a portfolio

Why hold an asset with lower expected returns than stocks at all? Four reasons:

1. Shock absorber. Stocks periodically fall 30% to 50%. High-quality bonds usually fall far less and sometimes rise in those episodes (in 2008, Treasuries rallied strongly while stocks were cut roughly in half). A 60/40 portfolio experiences dramatically shallower drawdowns than 100% stocks. The honest caveat: when the shock is inflation itself, as in 2022, stocks and bonds can fall together. Bonds are a good diversifier against growth scares, an unreliable one against inflation surprises; that is what TIPS and I bonds are for.

2. Behavioral insurance. The investor who panic-sells stocks at the bottom does more damage than any expense ratio ever could. A bond allocation that keeps your worst-case loss inside your sleep-at-night threshold is what keeps you invested through the crash, which is where long-term returns actually come from.

3. Rebalancing ammunition. When stocks crater, a bond allocation gives you something stable to sell in order to buy stocks cheap, mechanically enforcing buy-low behavior. The next guide works this example in detail.

4. Income and known payments. For retirees, bonds and bond ladders convert a lump of savings into a dependable stream of payments, reducing the need to sell stocks in a downturn.

How much in bonds is the central question of asset allocation, which is exactly where this course goes next.