What are Bonds and How Do They Work?

Disclaimer: The content below is for educational and informational purposes only and does not constitute investment advice, personal recommendations, or a solicitation to buy or sell financial instruments. Investing involves risks, including potential loss of capital. Past performance is not indicative of future results. Investors should consult a qualified financial advisor or conduct their own research before making investment decisions.

Total sovereign and corporate bond debt worldwide has surpassed $100 trillion in 2025. This number shows the sheer size of the global bond market and that it is the largest securities market in the world. For investors and traders, this provides access to abundant investment opportunities and diversification. Investors should note that bond investments carry risks, including interest rate, credit, and market risks.

If you are new to investing, you must be wondering: What are bonds? While in its true form, it is defined as a debt instrument where you lend money to a company. In this bond market basics guide, we will understand "what are bonds" and 'how do bonds work".

What are Bonds? Bonds Explained for Beginners

A bond is a loan that the bond purchaser or bondholder offers to an entity that issues it, which can be either a government or a corporation. It comes with an agreement to recover the loan with interest. By size, the bond market is the biggest financial market in the world.

Bonds are a means by which organisations, including international institutions and global companies, borrow funds from investors like you. You are a lender and exposed to credit and market risk.

The issuer, in turn, agrees to pay you interest, typically at regular intervals. This interest is referred to as a coupon. At the maturity date of the bond, the issuer repays the amount that you invested, which is referred to as the principal. Here is how bonds are different from stocks:

What are the Benefits of Bonds

Here are the key benefits of bonds you must know:

Less risk than stocks: Bonds may be less volatile than stocks but still carry market, interest rate, and credit risks.
Stable revenue: Consistent interest (coupon) payments offer a stable cash flow.
Portfolio stability: Due to reduced risk, bonds are the best to invest in when the investor has less time to recuperate losses.
Fund local initiatives: Municipal bonds allow you to invest in schools, hospitals and other local projects and receive returns.

What Determines the Price of a Bond in the Market?

Once the bonds are issued, they can be sold and purchased in the secondary market. Others are traded publicly on exchanges, although the majority are traded over-the-counter, between large broker-dealers on behalf of a client or themselves.

The price and yield of the bond determine the value of a bond in this market. The price is merely what the investors are ready to pay to either sell or purchase the bond. The yield is the actual annual rate of return of the bond in case it is held till maturity, and it is based on the coupon payments of the bond and the price at which the bond is purchased.

That is, the price of the bond influences the amount of income you will get, and the yield indicates the amount of income you can actually get. Price risk exists if bonds are sold before maturity.

What is Yield to Maturity (YTM)?

Yield to Maturity (YTM) is the real rate of return you get on a bond in case you hold it till it matures. Although the coupon reflects the interest that the bond pays, YTM takes into consideration the price that you pay for the bond and the price that you get at the end of the bond. Consider it as purchasing a rental house:

Scenario 1: You purchase the property at a fair price, rent it and sell at the same price. Your net yield will be the same as the rental yield.
Scenario 2: You purchase at a greater price than the sale price, wherein your net yield decreases.
Scenario 3: You purchase at a lower price than the sale price, wherein your net yield goes up.

How Do Bonds Work?

There are three main components of bonds that work together coherently: principal, coupon rate and maturity date. Here is a step-by-step breakdown of how bonds and these components work together:

1. Face Value (Principal)

Face value is what you loan out to the issuer when you purchase a bond. It is also the value that the issuer will pay back upon maturity. Suppose you purchase a bond that has a face value of $1,000. At the expiry of the bond term, the issuer repays the $1,000 to you.

2. Coupon Rate (Interest)

Coupon rate is the interest that the issuer pays you, better known as the bond income. It is normally paid at a regular period (monthly, quarterly, or annually). Suppose your $1000 bond has a 5% coupon rate. It means you will receive a yearly payment of $50 until the bond matures.

3. Maturity Date

Maturity date is the date on which the bond issued will expire, and the issuer will give you back your principal. The terms of the bonds may be a few months or 30 years, or above. A 10-year bond bought today means you will receive your $1,000 back in 10 years, plus all the interest payments in between.

4. Bond Market (Secondary Market) Trading

Bonds are not just held until they mature; they can be sold and bought on the bond market. The prices may increase or decrease based on the interest rates, the creditworthiness of the issuer, and the demand in the world market. When interest rates decline, your 5% bond will be more valuable since it will pay higher interest than the new bonds. Before maturity, you could sell it for over $1,000. Secondary market trading carries price and interest rate risk.

Bond Market Basics: What Every Investor Should Know

Bonds are sold, bought, and traded in the financial market around the world. It presents investment opportunities to both big and small investors. To sail through it, you must know a few important concepts, like the following:

1. Liquidity

Liquidity refers to the ease with which you can buy or sell a bond without much influence on its price. A bond is liquid when you can buy and sell it in the financial market with ease. If a bond is illiquid, you will find it difficult to sell the bond, and even if you do, you will have to sell it at a lower price since there are fewer investors interested in investing in bonds.

2. Credit Risk

Credit risk is the possibility that the issuer will fail to make interest payments or repay principal. Here are the key components of credit risk:

Probability of Default (PD): The probability that the borrower will default in a given time period.
Loss Given Default (LGD): This is the value of the investment that will be lost in case of default, after any collateral or collection recoveries.
Exposure at Default (EAD): The total amount a lender is exposed to at the time of default.
Credit Migration Risk: The risk that a rating agency will downgrade a bond's credit rating due to the issuer's deteriorating financial health, causing the price to fall in secondary markets.
Credit Spread Risk: It is the risk that the credit spread (the additional yield that a risky bond will pay, compared to a risk-free government bond) will increase, and the price of the bond will fall. Even highly-rated bonds carry some credit risk.

Borrowing from a highly-rated international firm is like lending to a trustworthy borrower, which has low risk. If you are funding a new business, it is the same as putting your trust in a person you hardly know.

3. Interest Rate Risk

Interest rate risk occurs when the prices of bonds change as a result of variations in global interest rates. Imagine a seesaw: when new bonds pay higher interest, older bonds with lower rates become less valuable, and vice versa. Long-term bonds tend to be more susceptible to interest rate fluctuations compared to short-term bonds. Price risk is greater for long-duration bonds.

How Bonds are Rated

Here is how bonds are rated in the global financial markets:

How to Invest in Bonds

Here is how you can invest in the bonds:

Set up your account: Open a trading and brokerage account to get access to government and corporate bonds.
Provide documents: Provide documents such as ID proof, bank account details and Demat information to adhere to regulations.
Explore bond options: Choose a type of bond you want to invest in from government, municipal, corporate, high-yield, mortgage-backed, floating rate, zero-coupon, convertible and inflation-protected bonds.
Compare bonds: Compare interest rate (coupon), duration (maturity) and credit rating to select what suits your objectives and risk profile.
Invest in bonds: Buy the bonds you want to invest in using the brokerage platform and begin to receive interest payments.
Monitor your investment: Monitor interest payments, market dynamics, and credit ratings. You may hold till maturity or sell in the secondary market where necessary. Holding to maturity reduces market risk, but secondary market price risk exists.

Top Bond Investment Strategies You Must Know

These are the top bond investment strategies you can use to strike a balance between risk and return:

1. Laddering

In laddering, you purchase bonds which will mature at various times. In this way, you have cash flow and flexibility as some of the bonds mature every year. It reduces interest rate risk and gives frequent chances to reinvest at existing rates.

2. Diversification

Diversification refers to the investing in different types of bonds, such as a combination of government, corporate, short-term and long-term bonds. It balances safety and return and insures against the performance of a single type of bond.

3. Income-Focused

This strategy is aimed at buying bonds that have higher coupon payments to earn a stable income. Here is why it works:

Useful for retirees or anyone seeking a predictable cash flow.
Focuses on maximising interest income rather than capital gains.

Conclusion

Bonds not only offer stability but also help you offset the fluctuations of other investments, such as stocks, in terms of creating a portfolio. Bonds also open up a broad spectrum of opportunities in markets and industries. This further reduces risk and opens doors to different markets. Before investing in bonds, however, you must compare different types and choose the one that best aligns with your investment objectives. Investors must compare bond types, yields, maturities, and credit ratings to align with objectives and understand associated market, interest rate, and credit risks.

Disclaimer: This content is for educational purposes only and does not constitute investment advice, personal recommendations, or a solicitation to buy or sell financial instruments. All investments involve risk, including potential loss of capital. Investors should consult professional financial advisors and consider their personal circumstances before making any investment decision.