The core characteristics of bonds are par value, coupon rate, and maturity date, and layered on top of those are the issuer type, credit rating, any embedded call or put options, and the tax treatment of the interest. Those features interact with each other and with market conditions to determine the bond’s price, its yield, and the kinds of risk you take on by owning it.
The Three Core Features
Par value is the principal the issuer promises to repay at maturity. In the U.S. market, par is usually $1,000, though some bonds use $100 increments.1Legal Information Institute. Par Value It also serves as the base figure for calculating interest.
The coupon rate is the annual interest the issuer pays, expressed as a percentage of par. A $1,000 bond with a 5% coupon pays $50 per year, typically in two semiannual installments of $25. That rate is locked in at issuance and does not change, which is why bonds are called fixed-income securities. The coupon is distinct from the bond’s yield, which moves with the market price.
The maturity date is when the issuer must repay par. Bonds are loosely grouped as short-term (roughly one to five years), intermediate (five to ten), and long-term (beyond ten). Longer maturities generally pay higher coupons to compensate for locking money up longer. Treasury bills, for comparison, mature in one year or less, and Treasury bonds can run out to 30 years.2TreasuryDirect. Treasury Bills
How the Coupon Is Paid
Not every bond pays interest the same way, and the structure matters for both income predictability and price volatility.
Fixed-Rate Bonds
Most bonds are fixed-rate. The coupon is set at issuance and stays the same until maturity. Cash flow is completely predictable. The trade-off is that when market rates rise, the fixed payment looks less attractive next to new issues, and the bond’s market price drops.
Floating-Rate Bonds
A floating-rate bond’s coupon resets periodically based on a benchmark rate plus a fixed spread. If the benchmark is a three-month Treasury bill rate of 2% and the spread is 0.40%, the coupon pays 2.40%. When the benchmark moves, the next payment adjusts. Because the coupon tracks market rates, floaters experience much less price fluctuation than comparable fixed-rate bonds. The initial coupon is usually lower, though, and some floaters include a cap limiting how high the coupon can go or a floor setting a minimum payment.
Zero-Coupon Bonds
Zero-coupon bonds pay no interest during their life. They sell at a steep discount to par, and the return is the difference between purchase price and the par value received at maturity.3Investor.gov. Zero Coupon Bond A $1,000 par zero with 20 years to maturity might sell for $450.
The catch is the tax treatment. Even though no cash arrives until maturity, the IRS requires you to report the annual increase in value as income each year, often called phantom interest. The code treats the yearly accretion of original issue discount as gross income, and your cost basis in the bond increases by the same amount each year.4Office of the Law Revision Counsel. 26 USC 1272 – Current Inclusion in Income of Original Issue Discount That is why zeros tend to be held inside tax-advantaged accounts like IRAs. Their prices also swing more sharply than coupon-paying bonds when interest rates change, since there are no periodic payments to soften the move.3Investor.gov. Zero Coupon Bond
Who Issues the Bond
The issuer shapes a bond’s risk and its tax treatment as much as any other feature.
- U.S. Treasury securities carry the lowest credit risk of any bond because they are backed by the full faith and credit of the federal government. They come as Treasury bills (one year or less), notes (two to ten years), and bonds (twenty to thirty years).5TreasuryDirect. About Treasury Marketable Securities
- Municipal bonds are issued by state and local governments. The interest is generally excluded from federal income tax, and often from state and local taxes if you live in the issuing state. That tax advantage means munis can offer lower coupons while still producing competitive after-tax returns.6Municipal Securities Rulemaking Board. Municipal Bond Basics
- Corporate bonds are issued by companies to fund operations, acquisitions, or capital spending. They carry higher credit risk than government debt, and the interest is fully taxable as ordinary income. Higher risk plus full taxability generally means the highest coupons of the three main categories.7Internal Revenue Service. Topic No. 403, Interest Received
- Agency bonds are issued by government-sponsored enterprises like Fannie Mae and Freddie Mac. These are not backed by the full faith and credit of the United States and carry slightly more credit risk than Treasuries. Ginnie Mae is an exception and does carry the government’s full backing.
Credit Quality
A credit rating is an independent assessment of the issuer’s ability to make interest payments and return principal on time. Ratings split bonds into two broad camps. Investment-grade bonds, rated BBB- and above on the S&P scale, come from issuers with relatively low default risk. Speculative-grade bonds, rated BB+ and below, carry meaningfully higher default risk and are often called junk bonds. S&P’s historical data shows a three-year cumulative default rate of about 0.91% for BBB-rated companies, rising to 4.17% for BB and 12.41% for B.8S&P Global. Understanding Credit Ratings Speculative-grade issuers compensate buyers with higher coupons, which is where the high-yield label comes from.
Secured vs. Unsecured
Whether a bond is backed by specific assets affects what happens if the issuer defaults. A secured bond is backed by collateral such as real estate, equipment, or receivables. If the issuer fails to pay, holders can claim and sell those assets. An unsecured bond, often called a debenture, is backed only by the issuer’s general creditworthiness; in a default, unsecured holders stand behind secured creditors in the repayment line and may recover much less of their principal.
This distinction shows up in the coupon. Secured bonds can offer lower rates because collateral reduces the investor’s risk. Unsecured bonds pay more to attract buyers willing to accept a weaker claim.
Call and Put Features
Some bonds carry embedded options that let either the issuer or the investor act before maturity, and those options change the bond’s risk profile in important ways.
A callable bond lets the issuer buy back the bond early, typically after an initial call protection period. Many municipal bonds, for example, become callable ten years after issuance.9FINRA. Callable Bonds: Be Aware That Your Issuer May Come Calling Issuers call bonds when rates have fallen since issuance, so they can refinance cheaper. For the investor, that means losing the bond at the worst time: a small call premium above par might cushion the blow, but you still have to reinvest the cash at today’s lower rates.
A putable bond is the mirror image. It gives the holder the right to sell the bond back to the issuer at par before maturity, which protects against rising rates because you can cash out and reinvest at the new, higher yields. Putable bonds yield less than otherwise comparable bonds, since the downside protection is already built in.
Coupon Rate vs. Yield
The coupon rate tells you what the bond pays relative to par. Yield tells you what you actually earn relative to the price you paid. Because bonds trade in a secondary market where prices move constantly, yield is the better number for comparing investments.
Current Yield
Current yield divides the annual interest payment by the current market price. A bond paying $50 a year that trades at $950 has a current yield of 5.26%. Useful for gauging income right now, but it ignores the fact that if you hold that discounted bond to maturity, you also collect $50 more in principal than you paid.
Yield to Maturity
Yield to maturity (YTM) is the more complete measure. It calculates the total annualized return if you buy at today’s price and hold to maturity, assuming coupon payments are reinvested at the same rate. It bakes in the coupon, the current price, and any capital gain or loss at maturity.
When a bond trades below par (at a discount), YTM is higher than the coupon rate because the return includes a built-in capital gain. When a bond trades above par (at a premium), YTM is lower than the coupon rate because the capital loss at maturity drags down the total return.
Real Yield
Those yields are nominal and ignore inflation. The real yield subtracts the inflation rate from the nominal yield. A bond yielding 5% in a 3% inflation environment delivers roughly 2% in real purchasing power. When inflation runs above the nominal yield, the real yield turns negative. Treasury Inflation-Protected Securities adjust principal in step with the Consumer Price Index, so the coupon payment rises with inflation and the investor receives at least the original principal at maturity.
Why Prices Move Opposite to Yields
Bond prices and yields move in opposite directions, and this is the single most important market dynamic to internalize. It follows directly from the fact that the coupon is fixed.
When market rates rise, new bonds offer higher coupons, so an existing bond with a lower coupon has to get cheaper until its effective yield matches the going rate. Nobody will pay full price for a 4% bond when new issues pay 6%. The price falls far enough that a buyer earns a competitive total return once the capital gain from buying below par is included.10Federal Reserve Bank of St. Louis. Why Do Bond Prices and Interest Rates Move in Opposite Directions
The reverse happens when rates fall. An existing bond with a higher coupon becomes valuable, and buyers bid the price above par. The premium reduces YTM to match current market rates, because the capital loss at maturity offsets the advantage of the higher coupon.
Duration: How Much Prices Move
Not every bond reacts equally to a rate change. Duration measures how sensitive a bond’s price is to a shift in rates. Expressed in years, it works as a rough estimate: for every 1% change in rates, the price moves about 1% in the opposite direction for each year of duration. A bond with a duration of five years loses roughly 5% if rates rise 1%, and gains about 5% if rates fall 1%.
Longer maturities increase duration. Higher coupons reduce it, because more cash flow arrives sooner. Zero-coupon bonds have the highest duration for their maturity because the entire payoff sits at the end. The practical takeaway: if you expect rates to rise, shorter-duration bonds will lose less value; if you expect rates to fall, longer-duration bonds deliver bigger gains.
The Main Risks
Bonds are often considered safer than stocks, and often they are. Safer is not risk-free, and the risks hit different bonds in different ways.
- Interest rate risk is the chance that rising rates push the market price down. It is the dominant risk for high-quality bonds and hits long-duration bonds hardest. Hold to maturity and you still get par back, but you give up the chance to earn higher rates elsewhere.
- Inflation risk erodes what fixed coupon payments can buy. A 4% coupon sounds fine until inflation runs at 5% and your real return goes negative. Longer-term bonds suffer most because the erosion compounds over many years.
- Credit risk is the chance the issuer defaults on interest or principal. Ratings offer a starting point, but ratings change. A downgrade from investment grade to speculative grade can send a bond’s price down sharply even without an actual default.
- Call and reinvestment risk applies to callable bonds, which can be redeemed early when rates drop. The issuer refinances cheaply while you lose a high-yielding position at the worst possible moment.
- Liquidity risk is the risk of not being able to sell quickly at a fair price. Thinly traded bonds have wide bid-ask spreads, so exiting costs you real money. Treasuries are highly liquid; small corporate issues or obscure municipal bonds often are not.
These risks stack. A lower-rated corporate bond with a long maturity and a call provision combines interest rate risk, credit risk, and call risk on top of each other. Knowing which risks apply to a particular bond is half the work of analyzing it.
How Bonds Trade
Unlike stocks, which trade on centralized exchanges with visible real-time prices, most bonds trade over the counter. Transactions happen between dealers and investors rather than through a single order book. Price transparency is lower, and transaction costs can be higher, especially for less actively traded issues. Government bonds trade constantly with tight spreads; many corporate and municipal bonds can go days or weeks without a single trade.
Buying between coupon payment dates triggers accrued interest. You owe the seller interest covering the period from the last payment date up to settlement, and then you collect the full next coupon as the new owner. This is standard market practice; the accrued amount is added to the purchase price at settlement.
Tax Treatment of Bond Income
How bond income is taxed depends on the issuer and on whether you hold to maturity or sell early.
Interest from corporate bonds is taxed as ordinary income at the federal level and typically at the state level too.7Internal Revenue Service. Topic No. 403, Interest Received Treasury interest is federally taxable but exempt from state and local income taxes. Municipal bond interest is generally exempt from federal income tax, and if you live in the state that issued the bond, often from state and local taxes as well.6Municipal Securities Rulemaking Board. Municipal Bond Basics Out-of-state municipal interest is still federally tax-free but usually subject to your own state’s income tax.11Internal Revenue Service. Publication 4079 – Tax-Exempt Governmental Bonds
Sell a bond before maturity for more than you paid and the profit is a capital gain. Hold longer than a year and it is taxed at long-term capital gains rates of 0%, 15%, or 20%, depending on income. Held for a year or less, the gain is taxed as ordinary income.
Zero-coupon bonds add their own wrinkle. Even without any cash in hand, you must report a portion of the original issue discount as income each year.4Office of the Law Revision Counsel. 26 USC 1272 – Current Inclusion in Income of Original Issue Discount Your cost basis rises by the amount reported, which reduces the taxable gain when the bond matures. Holding zeros in a tax-deferred account like a traditional IRA avoids the annual phantom-income problem.