Advanced Topics · Lesson 2 of 5
Bonds Deep Dive: Duration, Yield, and Credit Risk
Key takeaways
- Bond prices and market yields move inversely: when rates rise, existing bonds’ fixed coupons become less attractive and their prices fall.
- Duration measures rate sensitivity: a 6-year-duration bond falls roughly 6% when rates rise one percentage point.
- Credit risk is compensated by yield spread — the extra income of corporate and high-yield bonds over Treasuries.
- Yield to maturity, not the coupon, is the return that matters when buying a bond at market price.
The asset classes lesson introduced bonds as loans with contractual payments. That contractual clarity hides a market that confuses many investors: bonds with fixed payments whose prices nevertheless move daily, sometimes sharply. This lesson builds the three concepts that explain nearly everything bonds do: the price–yield seesaw, duration, and credit risk.
The seesaw: why bond prices move at all
A bond's payments are fixed at issue — say a $1,000 bond paying a 3% coupon ($30/year) for ten years. Suppose market rates then rise, and newly issued comparable bonds pay 5%. Nobody will pay $1,000 for $30/year when $50/year is available at the same price — so the old bond's market price falls until its effective return matches the new environment (to roughly $845 in this case). Rates up, prices down; rates down, prices up. The payments never changed; the price of admission did.
This is why the yield to maturity (YTM) — the annualized return from buying at today's price and holding to repayment — is the number professionals quote, not the coupon. A 3% coupon bond bought at $845 yields about 5% to maturity.
Duration: rate sensitivity in one number
Duration, expressed in years, condenses a bond's rate sensitivity: price change ≈ −duration × change in rates. It rises with time to maturity and falls with coupon size. Practical anchors: money-market instruments have duration near zero; a total U.S. bond market fund sits near 6 years; 30-year Treasuries can exceed 17.
Duration explains the shock that greeted bond investors in 2022. The U.S. aggregate bond index lost roughly 13% — its worst year in modern records — not because issuers defaulted, but because the Federal Reserve raised rates about four percentage points and the index's ~6.5-year duration did the arithmetic. "Safe" bonds are safe from default, not from rate moves.
Worked example: two bonds meet a rate hike
An investor holds $10,000 in each of two hypothetical Treasury positions when market rates rise from 3% to 4% (a one-point move):
- 2-year note, duration ≈ 1.9: price change ≈ −1.9% → position falls to about $9,810. Its cash flows are repaid soon and can be reinvested at the new 4%.
- 30-year bond, duration ≈ 17: price change ≈ −17% → position falls to about $8,300. Three decades of now-below-market coupons got repriced at once.
Same issuer, same creditworthiness, same rate move — a ninefold difference in impact, entirely explained by duration. (The approximation works well for small moves; large moves add curvature effects called convexity.) A silver lining worth noting: after a rate rise, the forward-looking yield is higher — investors who keep holding and reinvesting coupons recover through improved income, over roughly a duration's worth of years.
Credit risk: the other dimension
Rate risk asks "what if rates change?"; credit risk asks "what if I'm not repaid?" The market prices it as a spread — extra yield over equivalent Treasuries. Rating agencies (Moody's, S&P, Fitch) grade issuers from AAA down; the line between investment grade (BBB−/Baa3 and above) and high yield ("junk") marks a real behavioral boundary. Historical five-year default rates run from a fraction of a percent for high-grade issuers to double digits for the speculative tiers — and high-yield bonds tend to fall alongside stocks in recessions, exactly when bond ballast is wanted. Spreads widen in fear and narrow in calm, adding a second source of price movement independent of rates.
The practical taxonomy investors use: Treasuries for rate exposure with negligible default risk; investment-grade corporates for modest extra yield with modest extra risk; high yield as a stock-like hybrid; TIPS for inflation linkage (see inflation); and broad bond index funds to hold the mix cheaply. Matching duration roughly to horizon — shorter bonds for nearer needs — is the standard way the pieces get assembled inside an allocation.
Common misconceptions
“Bonds can’t lose money.”
Bond funds and bonds sold before maturity lose value when rates rise — the aggregate U.S. bond index fell about 13% in 2022. Held-to-maturity Treasuries repay in full, but their owner still bears the opportunity cost and inflation erosion of below-market coupons.
“A higher coupon means a better bond.”
Coupons are backward-looking; the market has already repriced every bond so buyers earn the going yield for its risk. The relevant comparisons are yield to maturity, duration, and credit quality — a high coupon at a high price can yield less than a low coupon at a discount.
“High-yield bonds are just bonds with better returns.”
Their extra yield is compensation for meaningful default risk, and they historically sell off with stocks in recessions — weakening the diversification role that makes bonds valuable in a portfolio.