Fixed-Income Investments: A Beginner's Guide to Bonds and Treasury Yields

How a bond works

Every bond has a face value, also called par, typically 1,000 dollars for individual bonds, a coupon rate and a maturity date. A 10-year bond with a 4 percent coupon pays 40 dollars of interest per year on a 1,000-dollar face value, usually in two semiannual payments of 20 dollars, and repays 1,000 dollars at the end of year ten.

Once issued, bonds trade in the secondary market, and their prices change. A bond can trade above par, at a premium, or below par, at a discount. The return an investor earns depends on both the price paid and the coupon.

Why bond prices and yields move in opposite directions

A bond's yield is the return implied by its price and future payments. Yield to maturity is the annualized return an investor would earn by buying at today's price and holding until maturity, assuming all payments arrive as promised.

When market interest rates rise, newly issued bonds offer higher coupons, so existing bonds with lower coupons become less attractive and their prices fall until their yields match the market. When rates fall, existing bonds with higher coupons become more valuable and their prices rise. Price and yield therefore move inversely.

Treasury bills, notes, bonds and TIPS

The US Treasury issues several types of marketable securities. Because they are backed by the full faith and credit of the US government, they are generally treated as having minimal default risk, and their yields serve as reference rates for mortgages, corporate debt and valuations across markets.

• Treasury bills: maturities of one year or less, sold at a discount and repaid at face value.
• Treasury notes: maturities from two to ten years, with semiannual coupon payments.
• Treasury bonds: maturities of twenty and thirty years, also paying semiannual coupons.
• TIPS: Treasury Inflation-Protected Securities, whose principal adjusts with the Consumer Price Index.
• Floating rate notes: two-year securities whose interest resets with short-term bill rates.

Duration: measuring interest rate risk

Duration estimates how sensitive a bond's price is to changes in interest rates. As a rough guide, a bond with a modified duration of 7 will lose about 7 percent of its value if yields rise by one percentage point, and gain about 7 percent if yields fall by the same amount.

Longer maturities and lower coupons mean higher duration. That is why long-term bonds swing more than short-term bonds when rates move. The 2022 bond market, when rapidly rising rates produced large losses in long-duration bonds, illustrated this risk clearly. Investors who need stability usually favor shorter durations, while those seeking a hedge against recessions often hold some longer-duration government bonds.

Credit risk and the role of ratings

Bonds issued by companies and many governments carry credit risk, the possibility that the issuer fails to pay. Rating agencies such as S&P Global Ratings, Moody's and Fitch assess this risk. Bonds rated BBB- or Baa3 and above are considered investment grade, and those below are high yield, sometimes called junk bonds.

Investors demand extra yield for extra risk. The gap between a corporate bond's yield and a Treasury of similar maturity is called the credit spread. Spreads tend to widen when investors grow worried about the economy and narrow when confidence returns, so they are closely watched as a gauge of financial stress.

Other risks bond investors face

Interest rate and credit risk get most of the attention, but several other risks affect returns. They matter most for investors who rely on bonds for income or who buy individual issues rather than funds.

• Inflation risk: fixed payments lose purchasing power when prices rise faster than expected.
• Reinvestment risk: coupons and maturing principal may have to be reinvested at lower rates.
• Call risk: some corporate and municipal bonds can be redeemed early by the issuer, usually when rates have fallen.
• Liquidity risk: smaller or lower-rated issues can be difficult to sell quickly without accepting a lower price.

Reading the yield curve

The yield curve plots Treasury yields across maturities. Normally it slopes upward, with longer maturities paying more to compensate for tying up money longer. When short-term yields rise above long-term yields, the curve is inverted.

Inversions have often preceded US recessions, because they can signal that markets expect the central bank to cut rates as growth slows. The signal is imperfect: timing has varied widely, and the curve stayed inverted for an unusually long period from 2022 into 2024. Still, the curve's shape is one of the most followed indicators in finance.

Ways to invest in bonds

Individual Treasuries can be bought directly from the government through TreasuryDirect in the United States or through a brokerage account. Holding an individual bond to maturity removes price risk if the issuer pays as promised, though the investor still faces inflation and reinvestment risk.

Bond funds and exchange-traded funds offer diversification across many issues and maturities with small minimums, but they have no maturity date, so their prices continue to move with rates. Matching bond choices to the time horizon of each goal is the simplest way to put fixed income to work. All investments carry risk, and this guide is educational rather than personalized advice.