By Harry Prabandham · Updated September 28, 2026
Investing & Markets
Bond Basics: How Bonds, Yields and Duration Work
A bond is a loan that pays interest and returns principal at maturity. Bond prices fall when rates rise, and longer bonds move more.
Bond Basics: How Bonds, Yields and Duration Work
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What is a bond?
- A bond is a loan to a government, agency or company that usually pays fixed interest, the coupon, and returns face value at maturity.
- After issuance, bonds trade at market prices that move opposite to interest rates: when rates rise, existing bond prices fall.
- Yield to maturity is the annualized return if you buy at today's price, hold to maturity, and the issuer makes every payment.
- In a bankruptcy, bondholders are generally paid before stockholders, though full recovery is not assured.
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Full Guide
What is a bond?
- A bond is a loan to a government, agency or company that usually pays fixed interest, the coupon, and returns face value at maturity.
- After issuance, bonds trade at market prices that move opposite to interest rates: when rates rise, existing bond prices fall.
- Yield to maturity is the annualized return if you buy at today's price, hold to maturity, and the issuer makes every payment.
- In a bankruptcy, bondholders are generally paid before stockholders, though full recovery is not assured.
How does duration measure interest rate risk?
- Duration estimates how much a bond's price changes when rates move; a duration of six implies roughly a 6% price change for a one-point rate move.
- Longer maturities and lower coupons generally mean higher duration and larger price swings.
- Holding an individual bond to maturity avoids a realized price loss from rising rates if the issuer doesn't default, though you still earn the lower original rate.
- Matching duration to when the money will be needed is a common way to manage this risk.
Main types of bonds
- U.S. Treasuries are backed by the full faith and credit of the U.S. government, and their interest is exempt from state and local income tax.
- Investment-grade corporate bonds are rated BBB-/Baa3 or higher and pay more than Treasuries to compensate for credit risk.
- High-yield bonds are rated below investment grade and carry materially higher default risk.
- Municipal bond interest is generally exempt from federal income tax, and often from state tax for in-state residents; some private activity bonds are subject to AMT.
- Agency mortgage-backed securities add prepayment risk, because homeowners tend to refinance when rates fall.
Risks bond investors face
- Interest rate risk: prices fall when rates rise, more so for longer-duration bonds.
- Credit risk: the issuer may miss payments or be downgraded, which lowers the bond's price.
- Inflation risk: fixed payments buy less when prices rise.
- Call and reinvestment risk: issuers may repay callable bonds early when rates fall, leaving you to reinvest at lower yields.
How do TIPS and I bonds adjust for inflation?
- TIPS principal adjusts with the Consumer Price Index, interest is paid on the adjusted principal, and at maturity you receive the greater of adjusted or original principal.
- The yearly inflation adjustment to TIPS principal is federally taxable when it occurs, even though you don't receive it until maturity.
- I bonds pair a fixed rate with an inflation rate reset every six months; purchases are capped at $10,000 per person per year, and the paper tax-refund option ended in 2025.
- I bonds can't be cashed in the first 12 months, and cashing in before five years forfeits the last three months of interest.
Key takeaways
- Bonds pay interest and return principal, but their market prices move opposite to interest rates.
- Duration is the main gauge of rate sensitivity; credit quality is the main gauge of default risk.
- Treasury, municipal and corporate bonds are taxed differently, which affects after-tax yield.
- TIPS and I bonds address inflation risk, with their own tax rules and purchase limits.
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