Fixed Income

The contract comes before the price

A bond is a financing contract. An investor advances capital; an issuer promises interest, principal and specific protections on a schedule. The market price is the current value of that promise after time, interest rates, inflation, credit quality, liquidity and optionality have been considered.

Start with the contract rather than the yield. Identify the issuer, currency, maturity, coupon, payment frequency, seniority, collateral, covenants and embedded options. A sovereign bond, a secured corporate note and a subordinated bank bond can display similar yields while transferring very different risks.

“Fixed income” does not mean fixed market value or fixed real income. A fixed coupon loses purchasing power when inflation is higher than expected. A bond sold before maturity is exposed to the yield available at the sale date. A promised payment is valuable only to the extent that the issuer can and will make it.

Price, yield and time

The price of a conventional bond is the discounted value of its future coupons and principal. In compact form: P = Σ CFₜ / (1 + y)ᵗ. The discount rate is the return the market currently requires for that cash-flow pattern and risk.

Because the cash flows are fixed, price and yield move in opposite directions. If new bonds offer a higher yield, an existing lower-coupon bond must trade at a discount to compete. If required yield falls below the coupon rate, the existing bond can trade above par. At maturity, a performing bond converges toward the principal repayment.

Coupon rate, current yield and yield to maturity answer different questions. Coupon rate divides the contractual coupon by face value. Current yield divides it by today’s price. Yield to maturity is the single discount rate that equates the market price with all promised cash flows, assuming they occur as scheduled and interim coupons can be reinvested consistently. It is a pricing summary, not a guaranteed realized return.

Duration and convexity

Maturity says when principal is due. Duration asks when the bond’s discounted value is economically received and translates that timing into interest-rate sensitivity. Modified duration approximates the percentage price change produced by a small parallel change in yield: ΔP / P ≈ −Dmod × Δy.

A ten-year zero-coupon bond has more duration than a ten-year high-coupon bond because all of its value arrives at the end. Lower yields also tend to increase duration by putting more present-value weight on distant payments. Portfolio duration combines the sensitivities of the underlying instruments, not simply their stated maturities.

The price–yield relationship is curved, so duration is only a local approximation. Convexity captures the second-order effect: for an option-free bond, price generally rises more when yields fall than it declines for an equal yield increase. Callable bonds can lose this favorable shape because the issuer may refinance precisely when rates fall.

The yield curve and reinvestment

The yield curve compares required yields across maturities for related instruments. Its slope reflects more than a forecast of future short-term rates. Inflation uncertainty, term premia, central-bank policy, supply, collateral demand and investor mandates can all change the curve.

Owning a longer bond locks in a cash-flow schedule but creates duration risk. Owning a sequence of short bonds reduces duration but creates reinvestment risk: future principal may have to be invested at lower rates. A liability due on a known date can make a long bond safer for one investor even while its market price is more volatile.

Curve movements are not always parallel. Short yields can rise while long yields fall; one segment can cheapen relative to another. Key-rate duration assigns sensitivity to separate maturity points so a portfolio does not hide curve-shape risk inside one aggregate number.

Credit spreads, default and recovery

A credit spread is the additional yield over a reference rate for bearing the issuer and instrument risks. It compensates for expected default loss, but also for uncertainty around that loss, liquidity, risk aversion, financing conditions, taxes and features specific to the bond.

Default probability is only half of expected credit loss. Recovery determines how much value remains after default, and seniority, collateral and covenant protection influence that recovery. The same company can issue bonds with different loss profiles because their priority and security packages differ.

Spread widening can create a loss even when no default occurs. A holder who must sell, post collateral or report market value experiences the new price immediately. Credit analysis therefore connects borrower cash generation and leverage to instrument terms, market liquidity and the investor’s own funding horizon.

Bonds versus bond funds

An individual performing bond has a stated maturity and principal repayment. A bond fund is a rolling portfolio: as securities mature or leave its mandate, the fund replaces them. The fund therefore does not “mature” as a whole, and its net asset value continuously reflects current market prices.

The distinction changes planning. A ladder of individual bonds can align principal payments with known liabilities, though it still carries default, reinvestment and trading risk. A diversified fund can make access and credit diversification easier, but investors share the manager’s duration, turnover, pricing and redemption mechanics.

Exchange-traded bond funds add a second price: fund shares trade in the market while the underlying bonds may trade infrequently. Creation and redemption mechanisms usually connect the two. During stress, the ETF price can move faster than stale evaluated prices for the underlying portfolio, revealing rather than necessarily causing the cost of immediate liquidity.

Failure modes

Fixed-income mistakes often begin by treating yield as income detached from price and risk. The higher yield may be compensation for duration, subordination, a call option, weak liquidity or genuine default exposure.

The practical test is a cash-flow stress map. Reprice the instrument for rate and spread moves, identify which payments can be deferred or cancelled, estimate recovery under the actual seniority, and ask whether the investor can hold through the resulting mark-to-market loss.

Put it back in the Atlas

Fixed income is the contractual side of Products & Investing. Compare its senior claim with the residual ownership in Stocks & Ownership, use Derivatives to separate or hedge rate and credit exposures, and place those exposures inside Funds & Portfolios. Private Markets extends the logic into private credit, where valuation and liquidity become less observable.

The instrument connects directly to Banking & Credit, where the borrower’s financing capacity originates; Markets & Trading, where liquidity and price discovery occur; and Risk, where duration, credit concentration and funding constraints are controlled.

Sources and further reading

• Investor.gov — Bonds: bond mechanics and interest-rate, credit, inflation, liquidity and call risks.
• Investor.gov — Corporate Bonds: indentures, covenants, price–yield behavior, default and liquidity.
• FINRA — Bonds, Interest Rates and Duration: duration as an estimate of price sensitivity to yield changes.
• Investor.gov — Bond Funds and Income Funds: the structure and risks of bond funds.

These sources establish the instrument and investor-protection layer. The laboratories are explanatory models, not pricing systems or investment recommendations.