Bond Mechanics: How Bonds Actually Work

I'm Andy Temte and welcome to Money Lessons! Join me every Saturday morning for bite-sized lessons that are designed to improve financial literacy around the world. Today is January 17, 2026.

Last week, we concluded our journey through bond market history by discovering how World War II debt, institutional investors, electronic trading, and ETFs transformed bonds from elite investments into accessible tools anyone can use. Today's $55+ trillion bond market—rivaling the stock market as one of the two pillars of securities markets—represents the culmination of reforms dating back to the Great Depression and technologies that democratized access.

But here's the question we haven't answered yet: What exactly are you buying when you purchase a bond? Today, we're opening the hood to explore bond mechanics—the nuts and bolts of how these instruments actually work.

What Is a Bond?

At its core, a bond is remarkably simple: it's an IOU. When you buy a bond, you're lending money to someone—a government, a corporation, or a municipality—and they're promising to pay you back with interest.

Think of it this way: Remember from our August 2nd lesson how we explored interest as the price of money? A bond is that concept formalized into a legal contract. You give the borrower your money today. They promise to make regular interest payments and return your principal on a specific future date.

This is fundamentally different from buying stock, where you become a partial owner sharing in profits and losses. With a bond, you're a creditor with a legal claim to specific promised payments, regardless of how well or poorly the borrower is doing—unless they default entirely, which we explored on December 20th with France's Two-Thirds Bankruptcy.

The Three Key Numbers

Every bond has three numbers that define it completely:

Face Value (also called par value or principal): This is the amount the borrower promises to repay at maturity. Most bonds have a face value of $1,000. This is what you'll get back when the bond matures—assuming the borrower doesn't default.

Coupon Rate: This is the annual interest rate the borrower promises to pay, expressed as a percentage of face value. A bond with a 5% coupon pays 5% of its face value in interest each year. The term "coupon" comes from the days when bonds had physical coupons attached that you'd clip and mail in to receive interest payments. This is where the phrase "clipping coupons" originated.

Maturity Date: This is when the borrower promises to repay the face value. Bonds might mature in one year, ten years, or thirty years.

Let's use a concrete example: A $1,000 face value bond with a 5% coupon maturing in ten years. This bond will pay you $50 per year in interest (5% of $1,000) for ten years, then return your $1,000 principal when it matures.

How Bond Payments Actually Work

Most bonds pay interest semi-annually—twice per year. Our $1,000 bond with a 5% coupon would pay $25 every six months rather than $50 once annually. This practice became standard with U.S. Treasury bonds in the early 1800s and was adopted by railroad companies when they began issuing bonds in the 1860s. For example, Pacific Railroad bonds from 1865 paid interest every May 1st and November 1st—a pattern that continues in bond markets today.

Picture owning this bond: Every six months, a payment of $25 arrives in your account. This continues like clockwork for ten years—twenty total payments of $25 each. Then, with the final interest payment, you also receive your $1,000 face value back.

Bond Pricing: Par, Premium, and Discount

Here's where bonds get interesting. While the face value stays constant at $1,000, bonds don't always trade at face value. They trade at current market prices based on current market conditions.

When a bond trades at its face value—$1,000 in our example—it's trading "at par." When it trades above face value—say $1,050—it's trading "at a premium." When it trades below face value—perhaps $950—it's trading "at a discount."

Why would you pay $1,050 for a bond that only returns $1,000 at maturity? Because that bond's interest payments might be more attractive than what newly issued bonds are offering. Why would you pay only $950? Because that bond's interest payments are less attractive than current alternatives.

This brings us to the single most important concept in bond investing.

The Inverse Relationship: When Rates Rise, Prices Fall

This is the relationship every bond investor must understand: when interest rates rise, existing bond prices fall. When interest rates fall, existing bond prices rise.

Let's see why this happens using our example. Suppose you bought a $1,000 bond with a 5% coupon when it was issued—it pays you $50 per year. You paid $1,000 for it, so your yield is 5%.

Now suppose interest rates rise shortly after issuance and new bonds with similar risk are being issued with 6% coupons. New investors can buy a $1,000 bond that pays $60 per year.

What happens to your bond paying only $50 per year? Nobody will pay you $1,000 for it when they could get a new bond paying $60 annually for the same price. Your bond must trade at a discount.

The market will price your bond so that its yield matches current rates. Using present value calculations with semi-annual payments over the remaining ten years, your bond would trade at approximately $926, where the $50 annual interest plus the eventual return of $1,000 face value provides a 6% yield to maturity. Here, the discount from par value is $74.

The reverse is equally true. If interest rates fall to 4% and new bonds pay only $40 per year, your bond paying $50 becomes more valuable. Using the same present value approach, investors would pay approximately $1,082 for your bond. Here, the premium relative to par value is $82.

This inverse relationship exists because bond interest payments are fixed, but market interest rates constantly change. The price adjusts to keep yields competitive with current rates.

Some of you may be saying - ‘hey, wait a minute, in your example, the interest rate change was 1 percent up and down, but the discount and premium are not mirror images—for a 1 percent increase in rates, the discount was $74, but when rates decreased by the same amount, the premium was $82. This is because the price-yield function is nonlinear. In future lessons, we’ll talk about bond duration and bond convexity as measures of interest rate risk.

Why This Matters

Understanding bond mechanics is essential for making informed investment decisions. When you hear that "the Fed raised interest rates," you now understand that existing bond prices fell. When financial news discusses "yields rising," you know bond prices are falling.

But what exactly is yield? I've used the word several times today, and you may have noticed there's more to unpack. Next week, we'll explore the different ways to measure yield—nominal yield, current yield, yield to maturity, and yield to call—and discover why comparing the right yields is essential for evaluating bond investments.

Until next week...

Grace. Dignity. Compassion.

Tags: Financial Literacy, Bond Mechanics, Bond Investing, Interest Rates, Personal Finance, Fixed Income