A bond is a debt security that promises specified payments over time, usually periodic interest payments called coupons and repayment of principal at maturity.
How a bond works
When an investor buys a bond, the investor is lending to the issuer. The issuer may be:
- a government,
- a municipality,
- a financial institution,
- or a corporation.
If a bond has face value F, coupon C, and maturity T, its price is the present value of all promised cash flows:
Price = sum of discounted coupons + discounted principal
In more explicit form:
P = C/(1+r) + C/(1+r)^2 + ... + (C+F)/(1+r)^T
Why bond prices move
Bond prices move mainly because:
- market interest rates change,
- default risk changes,
- inflation expectations change,
- liquidity conditions change.
The basic relationship is inverse: when required yields rise, existing bond prices fall.
Why bonds matter in economics
Bonds are central to macroeconomics and finance because they connect saving, public borrowing, monetary policy, and credit risk. Government-bond yields affect discount rates across the economy, while corporate-bond spreads reflect how markets price default risk and business conditions.
Knowledge Check
### What is a bond in economic terms?
- [x] A loan packaged as a tradable security
- [ ] A claim to residual ownership in a firm
- [ ] A spot transaction in foreign exchange
- [ ] A futures contract on commodities
> **Explanation:** A bond represents debt. The bondholder is a lender, not an owner with residual control rights like an equity holder.
### Why do bond prices typically fall when market interest rates rise?
- [x] Because the bond's fixed payments are discounted at a higher required yield
- [ ] Because higher rates eliminate coupons
- [ ] Because bond maturities disappear
- [ ] Because governments forbid trading
> **Explanation:** Fixed future cash flows become less valuable today when the discount rate increases.
### Why are bonds important for macroeconomics?
- [x] Because they transmit borrowing costs, policy expectations, and credit conditions through the economy
- [ ] Because they are unrelated to government finance
- [ ] Because only households use them
- [ ] Because their prices never affect firms
> **Explanation:** Bond markets influence public debt service, corporate finance, portfolio allocation, and monetary-policy transmission.
### What payment is usually returned at maturity?
- [x] Principal or face value
- [ ] Only the market price gain
- [ ] Only the last coupon
- [ ] Only a dividend
> **Explanation:** At maturity the issuer typically repays the bond's principal in addition to any final coupon due.