Bonds Explained: How Prices, Yields, Maturity and Credit Risk Fit Together

A bond can keep paying exactly the interest promised and still fall in market value. That apparent contradiction becomes easier to understand once you separate the bond’s contractual terms—principal, coupon and maturity—from its changing market price and yield.

The basic cash-flow promise

Buying a bond means financing an issuer that promises specified interest payments and the return of principal. The principal is usually expressed as the bond’s face value or par value.

A bond’s maturity date is generally established when it is issued, and it marks when the borrower is due to make the final interest payment and repay par value. Maturity therefore answers a timing question: How long is the principal scheduled to remain outstanding?

The coupon answers a different question: How much stated interest does the bond pay? The coupon rate is set at issuance as a percentage of par value, with payments generally made twice a year. Many corporate bonds have fixed coupon rates, so their coupon payments remain unchanged even if market interest rates later move.

These terms are related but not interchangeable:

This resolves a common misunderstanding: a bond’s price is not its principal. The bond might trade above or below $1,000 while its contractual par value remains $1,000.

Coupon rate is not the same as yield

The coupon rate is calculated from par value. Yield reflects the return associated with the price an investor actually pays.

Yield to maturity expresses the annual return if the bond is held until maturity, accounting for when it was purchased and how much the buyer paid. It provides a broader comparison than coupon rate alone because two bonds with identical coupons can offer different yields if their prices differ.

The relationship between price, coupon and yield can be described in three cases:

• If yield to maturity equals the bond’s stated interest rate, the price is at par.
• If yield to maturity exceeds the interest rate, the bond’s price is below par value.
• If yield to maturity is below the stated interest rate, the bond’s price is above par value.

Suppose an existing bond pays 3% while newly issued bonds of comparable characteristics begin paying 2%. The existing 3% payment becomes more attractive, so its price can rise. A new buyer paying that higher price receives a lower yield to maturity. If comparable new bonds instead pay 4%, the existing 3% bond may need to fall in price to compete, raising its yield for a new buyer. This is why bond yield moves inversely to price even though the fixed coupon itself has not changed.

Why interest rates move bond prices

Bond prices and market interest rates generally move in opposite directions: rising rates tend to push existing bond prices down, while falling rates tend to lift them.

The mechanism is competition. An existing fixed-rate bond must compete with newly issued bonds. If new bonds offer higher coupons, buyers generally will not value the older, lower-paying bond as highly unless its price falls. If new bonds offer lower coupons, an older bond’s higher fixed payment can command a premium.

This creates interest-rate risk: the possibility that changing market rates will raise or reduce a bond’s market value. It is common to all bonds, including U.S. Treasury bonds, even though Treasury securities are generally viewed as free of default risk.

Not every bond reacts equally. Longer maturities generally carry greater interest-rate risk because there is more time for rates to change and affect the bond’s price. Among bonds that are otherwise the same, a lower-coupon bond is generally more sensitive to rate movements than a higher-coupon bond. For example, if two otherwise identical bonds have 2% and 4% coupons, the 2% bond’s price will generally fall by a greater percentage when market rates rise.

Even when trading prices swing, holding a bond to maturity means the stated interest continues and face value is due at maturity, subject to default risk. That qualification matters. Maturity removes the need to sell at an interim market price, but it does not ensure that the issuer will make every promised payment.

Credit risk is a separate problem

Interest-rate risk concerns changes in market value caused by rates. Credit risk, also called default risk, concerns whether the issuer will pay at all.

Credit or default risk is the possibility that an issuer will fail to make an interest payment or repay principal when the bond matures. A company’s ability to meet its obligations on time is therefore central to evaluating a corporate bond.

Credit ratings can help organize that analysis, but they are limited. Credit ratings are third-party estimates of relative credit risk rather than guarantees or recommendations. A higher rating reflects the rating agency’s assessment of a lower likelihood of default relative to a lower-rated obligation, and ratings may be revised as conditions or expectations change.

They are not an all-purpose measure of bond safety. Credit ratings do not cover interest-rate, market or liquidity risk and do not account for the price at which a security is offered or sold. Two bonds with the same rating could therefore have different maturities, coupons, prices and exposure to changing rates.

A useful way to read any bond is to ask the questions in order: What principal is due? What coupon is promised? When does it mature? What price must be paid today? What yield does that price imply if held to maturity? Finally, what could prevent the issuer from making the promised payments? Keeping those questions separate prevents a high coupon, attractive yield or strong rating from being mistaken for a complete description of the bond’s risks.

Sources

1. Bonds | FINRA.org — finra.org
2. What Are Corporate Bonds? — investor.gov
3. Understanding Pricing and Interest Rates — TreasuryDirect — treasurydirect.services.treasury.gov
4. What Are Corporate Bonds? — sec.gov
5. Updated Investor Bulletin: The ABCs of Credit Ratings | Investor.gov — investor.gov