Bonds Explained: Yields, Duration, and Why Bond Prices Move
Bonds are called the safe part of a portfolio — yet 2022 delivered the worst bond drawdown in modern history. Here's how bonds actually work, from coupons and yields to duration and the yield curve.
By 360head Research Desk · Reviewed for accuracy · Informational only, not financial advice.
- A bond is a loan with fixed terms: you lend principal, collect coupons, and get principal back at maturity — if the issuer pays.
- Bond prices and yields move in opposite directions; duration tells you roughly how much a bond's price moves per 1% change in yields.
- Credit ratings grade default risk; higher yield is compensation for higher risk, never a free lunch.
- Inverted yield curves have preceded most U.S. recessions, but with long, variable lags — they are a signal, not a clock.
- 'Safe' is not the same as 'cannot fall': in 2022, the broad U.S. bond market had its worst year on record even without a wave of defaults.
Executive Summary
A bond is a loan with fixed terms: an investor lends money to a government or company, the borrower pays interest (the coupon) on a schedule, and the original amount (the principal or face value) comes back on a set date (the maturity). That simple definition hides the part that surprises most beginners: once a bond is issued, it trades on a secondary market, and its price moves every day — usually in the opposite direction of interest rates.
This guide explains how bonds work from the ground up: the difference between a coupon and a yield, the price-yield seesaw, duration as a measure of interest-rate sensitivity, credit ratings and default risk, the differences between Treasuries, corporate bonds, and municipal bonds, what the yield curve is and what an inversion has historically signaled, and the practical choice between bond funds and individual bonds. We close with the lesson of 2022 — the year the broad U.S. bond market fell roughly 13%, its worst calendar-year performance since the Bloomberg U.S. Aggregate Bond Index began in 1976 — to make one idea stick: safe is not the same as cannot fall.
What Is a Bond? A Loan with Fixed Terms
When a government or corporation needs to borrow money, it can go to a bank — or it can go to the public. A bond is how it goes to the public. Instead of one large bank loan, the borrower splits the borrowing into thousands of small, standardized pieces and sells them to investors. Each bond is a contract: you lend us $1,000 today, we pay you a fixed amount of interest every six months, and on a specific future date we hand your $1,000 back.
Five terms define every bond, and they are worth memorizing because everything else in this article builds on them:
- Issuer: the borrower — the U.S. Treasury, a state or city, or a company.
- Face value (par, principal): the amount the issuer borrows per bond and repays at maturity, conventionally $1,000 in the U.S. corporate market.
- Coupon rate: the annual interest rate applied to face value. A 5% coupon on a $1,000 bond pays $50 per year, typically in two $25 installments.
- Maturity date: the date the principal is repaid. Bonds are often grouped as short-term (under about 3 years), intermediate (roughly 3–10 years), and long-term (10–30 years).
- Price: what the bond trades for today, expressed as a percentage of face value. A price of 98 means $980 per $1,000 of face value.
Notice what is fixed and what is not. The coupon, the face value, and the maturity date are written into the contract and do not change for a standard fixed-rate bond. The price is not in the contract at all — it is set by the market, minute by minute, and it can drift above or below face value for years. That gap between a fixed contract and a floating price is where almost everything interesting about bonds lives.
Coupon vs. Yield: Two Numbers People Confuse
The coupon rate is the interest rate printed on the bond at birth. It never changes. The yield is the return an investor actually earns at today's price — and it moves constantly. Confusing the two is the single most common beginner mistake in fixed income.
Current yield
The simplest yield measure is the current yield: the annual coupon payment divided by the price you pay today. If a bond pays $50 per year and you can buy it for $950, your current yield is 50 / 950 = 5.26% — higher than the 5% coupon, because you bought the same cash flows at a discount. If you pay $1,050, the current yield drops to 50 / 1,050 = 4.76%. Same bond, same coupon, different yield, purely because the price moved.
| Price paid | Annual coupon | Current yield | Relationship |
|---|---|---|---|
| $950 (discount) | $50 | 5.26% | Yield above coupon |
| $1,000 (par) | $50 | 5.00% | Yield equals coupon |
| $1,050 (premium) | $50 | 4.76% | Yield below coupon |
Yield to maturity
The number professionals quote is yield to maturity (YTM): the total annualized return you would earn if you bought at today's price, collected every coupon, reinvested those coupons at the same rate, and held the bond to maturity. YTM folds in the coupons plus the built-in gain or loss between the price you pay and the $1,000 you receive at the end. Buy at $950 and your YTM exceeds your current yield, because you also pocket the $50 discount over time. Buy at $1,050 and it sits below, because the premium bleeds away. When a headline says "the 10-year Treasury yields 4.3%," it is quoting a yield to maturity, not a coupon.
Why Bond Prices and Yields Move in Opposite Directions
This is the mechanism at the heart of the whole article, and it is pure arithmetic, not market psychology. When market interest rates go up, existing bond prices tend to go down; when rates go down, existing bond prices tend to go up. Traders call it the price-yield seesaw.
The intuition: your bond must compete with new bonds
Suppose you own a bond paying a 4% coupon, and the central bank raises rates so that newly issued, otherwise identical bonds now pay 6%. Would anyone buy your 4% bond for the full $1,000? Of course not — they can get 6% fresh from the issuer. The only way your older bond can attract a buyer is if its price falls until its yield matches the new 6% reality. The coupon is stuck at $40 a year, so the price has to do all the adjusting. The reverse works identically: if new bonds only pay 2%, your 4% coupon is suddenly valuable, and buyers will pay more than face value to get it.
A bond, in other words, is a fixed stream of cash in a world where the going rate of interest keeps changing. The cash stream cannot move, so the price must. This is also why inflation, interest rates, and recessions are so tightly linked to bond markets: inflation expectations are the main driver of where interest rates go, and where rates go, bond prices follow in mirror image.
Does a price drop mean you lost money?
Only if you sell. If you hold an individual bond to maturity and the issuer does not default, you receive the contracted coupons and the full face value regardless of what the quoted price did in between. The interim price swings are real but unrealized. This is a crucial distinction from stocks, and it is why investors who need a known sum on a known date — a tuition bill, a home deposit — often match individual bonds to that date. The catch, covered below, is that inflation and opportunity cost are still real even when the nominal contract is honored, and bond funds do not offer this hold-to-maturity feature at all.
Duration: How Much a Bond's Price Moves When Rates Move
Duration is the single most useful risk number in fixed income. Formally, it is the weighted average time until a bond's cash flows arrive, expressed in years. Practically, it tells you a bond's sensitivity to interest rates: a bond's price tends to change by roughly its duration, in percent, for every 1-percentage-point move in yields — in the opposite direction.
| Duration (years) | If yields rise 1% | If yields fall 1% |
|---|---|---|
| 1 (short-term bond) | Price tends to fall ~1% | Price tends to rise ~1% |
| 6 (intermediate bond fund) | Price tends to fall ~6% | Price tends to rise ~6% |
| 17 (long-term Treasury) | Price tends to fall ~17% | Price tends to rise ~17% |
Three rules of thumb follow directly:
- Longer maturity, higher duration. Cash arriving in 30 years is discounted much harder by a rate change than cash arriving next year. A 3-month Treasury bill barely flinches when rates move; a 30-year bond can swing like a stock.
- Lower coupon, higher duration. A bond that pays most of its return at the end (a low coupon) is more rate-sensitive than one that pays generous coupons along the way. A zero-coupon bond, which pays nothing until maturity, has a duration equal to its full maturity.
- The rule is an approximation. The relationship between price and yield is slightly curved rather than a straight line — a refinement called convexity. For small rate moves the linear estimate is close; for very large moves, real prices do a bit better than the duration rule predicts.
Credit Ratings and Default Risk
Interest-rate risk is about the market; credit risk is about the borrower. Will the issuer actually make every payment? To help investors compare borrowers, independent rating agencies — Moody's, S&P Global Ratings, and Fitch — grade issuers on standardized scales.
| Grade | S&P / Fitch | Moody's | Meaning |
|---|---|---|---|
| Highest quality | AAA | Aaa | Extremely strong capacity to repay |
| High quality | AA | Aa | Very strong, small notch below top |
| Upper medium | A | A | Strong, somewhat more economy-sensitive |
| Lower medium | BBB | Baa | Adequate; the bottom of investment grade |
| Speculative ("high yield") | BB and below | Ba and below | Meaningful default risk; formerly "junk" |
The gap between the two worlds is real. In long-run S&P studies of global defaults, investment-grade defaults are rare — on the order of a small fraction of one percent of issuers per year on average — while speculative-grade default rates have historically averaged roughly 3–4% annually, spiking well into double digits during severe recessions such as 2009. Even when defaults happen, bondholders often recover a portion of their money in restructuring; historical recovery rates on senior bonds have averaged around 40–50 cents on the dollar, though outcomes vary widely by case.
The market expresses credit risk through the spread: the extra yield a corporate bond pays above a Treasury of the same maturity. A BBB-rated company might borrow at 1.5–2 percentage points over Treasuries in calm times and see that spread widen sharply in a panic. A higher yield is always compensation for something — more credit risk, more rate risk, or less liquidity. It is never a free upgrade, and "high-yield bond" is marketing's polite name for "lending to a weaker borrower."
Treasuries vs. Corporates vs. Municipal Bonds
The U.S. bond market is larger than the U.S. stock market — total outstanding debt securities exceed $50 trillion by Securities Industry and Financial Markets Association (SIFMA) estimates — and it divides into three main neighborhoods, each with a different risk and tax profile.
| Type | Issuer | Credit risk | Federal tax | State/local tax |
|---|---|---|---|---|
| Treasuries | U.S. federal government | Lowest; backed by full faith and credit of the U.S. | Taxable | Exempt |
| Corporates | Companies | Varies by rating, AAA to speculative | Taxable | Taxable |
| Municipals ("munis") | States, cities, agencies | Generally low, but real (defaults have occurred) | Generally exempt | Often exempt if issued in-state |
Treasuries come as bills (up to 1 year), notes (2–10 years), and bonds (20–30 years), and can be bought directly at TreasuryDirect without a broker. Because the U.S. government can tax and issue its own currency, Treasuries are treated in finance as the closest thing to a default-free benchmark — every other yield in the economy is priced as "Treasuries plus a spread." Two special flavors matter for households: TIPS (Treasury Inflation-Protected Securities), whose principal adjusts with the Consumer Price Index, and Series I savings bonds, whose composite rate combines a fixed rate with an inflation-linked rate — a design that briefly made headlines in 2022 when the annualized composite rate reached 9.62% while inflation was running hot.
Corporate bonds pay more because companies can fail. The entire credit-rating section above applies here, and the fundamental analysis is the same craft as equity analysis — reading balance sheets, interest coverage, and cash flow in filings on SEC EDGAR — just asked from the lender's chair instead of the owner's. If you already evaluate companies with the 360head Stockiq research tools, you will find the credit questions familiar: Can it cover its interest? How much debt matures soon? What is left for bondholders if things go wrong?
Municipal bonds fund roads, schools, and water systems. Their defining feature is tax treatment: interest is generally exempt from federal income tax, which means their yields look low until you adjust. A muni yielding 3.5% is equivalent to roughly 5.4% taxable for an investor in the 35% bracket (3.5 / (1 − 0.35)). That "taxable-equivalent yield" calculation is the correct way to compare a muni against a corporate or Treasury for your own situation, and a tax professional can confirm the details for your state and bracket.
The Yield Curve — and What an Inversion Signals
Plot Treasury yields across maturities — 3 months, 2 years, 10 years, 30 years — and connect the dots: that line is the yield curve. Normally it slopes upward, because lending for longer means more inflation risk and more duration risk, and investors demand extra yield as compensation. The most-watched single number is the gap between the 10-year and 2-year yields.
Sometimes the curve inverts: short-term yields rise above long-term ones. This typically happens when the central bank is pushing short rates up to fight inflation while the bond market simultaneously prices in slower growth or future rate cuts. Inversions matter because the historical record is striking: every U.S. recession since the 1970s has been preceded by a 10-year/2-year inversion. The 2022–2023 episode produced the deepest inversion since the early 1980s, at times around a full percentage point.
Honesty requires three caveats:
- The lag is long and variable. Historically, recessions have followed inversions by roughly 6 to 24 months — far too loose for timing a portfolio.
- The signal is not perfect. There have been brief inversions without a following recession (a very short one in 1998 is the classic example), and the 2022–2023 inversion was followed by years in which a widely predicted U.S. recession did not arrive on schedule.
- The mechanism can shift. When central banks hold enormous bond portfolios, as they have since 2008, long-term yields are partly managed prices, which may make the curve a noisier indicator than it was in earlier eras.
The right use of the yield curve is as a dashboard gauge, not a countdown timer: an inversion tells you the bond market collectively expects today's tight policy to give way to slower growth tomorrow. Treat it as one input alongside the broader picture on markets, not as a trade trigger.
Bond Funds vs. Individual Bonds
You can own bonds one at a time, or you can own them through a fund or ETF. The two experiences are more different than they look, and the difference comes down to maturity.
- Individual bonds have a maturity date. Barring default, you know what you will receive and when, which makes them ideal for matching a specific future expense. The downsides: building a diversified ladder takes meaningful capital (corporate bonds often trade in institutional-sized lots), pricing is less transparent for small trades, and selling early means accepting the market price.
- Bond funds and ETFs give instant diversification and daily liquidity for a low fee, and they are the practical default inside retirement accounts. But a fund never matures — the manager continually sells aging bonds and buys new ones to hold the fund's duration roughly constant. That means a fund's price rises and falls with rates forever; there is no date on which you are made whole. A fund's stated yield is also a moving snapshot, not a locked-in return.
The 2022 experience (next section) was felt far more sharply by fund holders than by investors holding short individual bonds to maturity. Neither vehicle is wrong; they solve different problems. Our guide to ETFs covers the fund mechanics in more depth, and the how it works page explains how 360head Stockiq thinks about risk across asset classes.
Bonds in a Portfolio: Ballast, Income, and the 2022 Lesson
Traditionally, bonds play two roles. First, income: a predictable coupon stream, which is why retirees and institutions with known liabilities lean on them. Second, ballast: because high-quality bonds have often risen or held steady when stocks sold off — especially when the central bank is cutting rates into a slowdown — they have historically cushioned a portfolio's worst months. The classic 60/40 portfolio (60% stocks, 40% bonds) is built entirely on this negative-correlation hope, and for most of the four decades before 2022, as yields trended down from the double-digit peaks of the early 1980s, it worked beautifully; bonds delivered both income and steady price gains.
What actually happened in 2022
Then inflation hit 40-year highs, and the Federal Reserve raised its policy rate from near zero to 4.25–4.50% within a single year — the fastest tightening cycle in four decades. The 10-year Treasury yield climbed from roughly 1.5% at the start of the year to a peak above 4%. Duration did exactly what the formula says it does, at scale:
- The Bloomberg U.S. Aggregate Bond Index — the standard benchmark for "the bond market" — fell about 13% for the year, its worst calendar year since the index began in 1976.
- Long-dated Treasury funds, with durations near 17, lost on the order of 30% — comparable to a bad year for the stock market.
- Stocks fell at the same time (the S&P 500 dropped roughly 18–19% including dividends), so the ballast failed precisely when it was needed: the classic 60/40 portfolio had one of its worst years on record.
Notice what did not happen: there was no wave of government defaults, no broken coupon payments on Treasuries. Every holder who held to maturity was paid in full, exactly on contract. The losses were pure interest-rate risk — duration risk — showing up through prices. "Safe" described the creditworthiness of the borrower, and it was accurate. It said nothing whatsoever about the price of the bond along the way.
The lessons that generalize
- Match duration to your horizon. Money needed in two years does not belong in a 17-duration instrument, no matter how creditworthy the issuer.
- Starting yield is a decent long-run compass. Historically, a broad bond portfolio's yield to maturity has been a reasonable guide to its subsequent multi-year return. Bonds bought at near-zero yields in 2020–2021 had almost no income cushion to absorb a rate shock; bonds bought at higher yields carry more cushion.
- Diversification is regime-dependent. Stock-bond correlation tends to be negative when growth scares dominate and positive when inflation scares dominate. 2022 was an inflation regime. Ballast works on average, not on every voyage.
- Short-term and inflation-linked instruments behaved very differently. Treasury bills and I Bonds sailed through 2022 with positive returns. "Bonds" is not one asset class but a spectrum from cash-like to stock-like volatility.
None of this argues against owning bonds. It argues for owning them with open eyes: as contracted cash flows whose market prices move, sometimes sharply, and whose real purchasing power still depends on inflation. For the income side of that equation, our dividend stocks guide covers the equity alternative and its very different risk profile, and the broader forces are mapped in inflation, interest rates, and recessions.
Frequently asked questions
A bond is a loan you make to a government or company. The borrower pays you a fixed interest rate (the coupon) on a schedule and repays your original principal on a set maturity date. Because bonds trade between investors, their market prices move daily — usually opposite to interest rates — even though the contract terms never change.
Existing bonds pay a fixed coupon, so when new bonds are issued at higher rates, the old ones must drop in price until their yield matches the new market rate. When rates fall, the older, higher coupons become more valuable and prices tend to rise. The size of the move is measured by the bond's duration.
High-quality bonds are generally less volatile than stocks and have a legal claim on payments, but they are not immune to losses. In 2022 the broad U.S. bond market fell about 13% — its worst year on record — purely from rising rates, with no defaults involved. Lower risk is not the same as no risk.
The coupon is the fixed annual interest payment set when the bond is issued, and it never changes. The yield is the return based on the price you pay today; yield to maturity also includes the gain or loss between your purchase price and the face value you receive at maturity.
It means short-term yields are above long-term yields, which historically has preceded most U.S. recessions. But the lag has ranged from about 6 to 24 months, brief inversions have occurred without recessions, and the 2022–2023 inversion was not followed by a recession on the expected schedule — treat it as a signal, not a timer.
It depends on the goal. Individual bonds held to maturity return a known amount on a known date (barring default), suiting specific future expenses. Bond funds offer instant diversification and liquidity but never mature, so their prices keep moving with rates. Many investors use funds for diversification and individual bonds or bills for date-specific needs.