Deep Dive: What Are Bonds and How Do They Work — A Complete Guide for Investors

A bond is essentially an IOU. When you buy a bond, you are lending money to the issuer — a government, corporation, or municipality — for a specified period. In return, the issuer agrees to pay you a fixed interest rate (called the coupon) at regular intervals and return your original investment (the face value or par value, typically $1,000 per bond) when the bond matures.

For example, if you purchase a 10-year Treasury bond with a 4% coupon rate and a $1,000 face value, you will receive $40 per year in interest payments (usually paid semi-annually as $20 every six months) for ten years. At the end of those ten years, you get your $1,000 back. This predictable income stream is what makes bonds attractive to conservative investors and retirees who need reliable cash flow.

Three key terms define every bond: the face value (the amount repaid at maturity), the coupon rate (the annual interest rate expressed as a percentage of face value), and the maturity date (when the issuer repays the principal). A bond's yield — the effective annual return based on its current market price — is distinct from its coupon rate because bond prices fluctuate in the secondary market. When a bond trades above face value, it is said to trade at a premium; below face value, at a discount.

Not all bonds carry the same risk or reward. The bond market spans a wide spectrum from ultra-safe government securities to higher-yielding corporate debt, and understanding the differences is critical for building a balanced fixed-income portfolio.

U.S. Treasury bonds are issued by the federal government and backed by the full faith and credit of the United States. They are considered virtually risk-free in terms of default, which is why they serve as the benchmark for all other bond pricing. Treasury securities come in three main flavors: Treasury bills (T-bills) with maturities of one year or less, Treasury notes (T-notes) maturing in 2 to 10 years, and Treasury bonds (T-bonds) with 20- or 30-year maturities. As of February 2026, the 2-year Treasury yields 3.47%, the 10-year yields 4.08%, and the 30-year yields 4.70%. Treasury Inflation-Protected Securities (TIPS) offer an additional hedge by adjusting their principal value with the Consumer Price Index.

Corporate bonds are issued by companies to fund operations, acquisitions, or capital expenditures. They carry higher yields than Treasuries to compensate for credit risk — the possibility that the company could default. Investment-grade corporate bonds (rated BBB- or above by major rating agencies) offer moderate yields with relatively low default risk, while high-yield or "junk" bonds (rated below BBB-) offer significantly higher interest rates to compensate for elevated default risk. The spread between corporate bond yields and Treasury yields — known as the credit spread — widens during economic uncertainty and narrows when confidence is high.

Municipal bonds (munis) are issued by state and local governments to finance public projects like roads, schools, and hospitals. Their key advantage is tax treatment: interest income from most municipal bonds is exempt from federal income tax and often from state taxes as well. This tax advantage makes munis particularly attractive for investors in higher tax brackets, even though their stated yields are typically lower than comparable corporate bonds.

Duration measures a bond's sensitivity to interest rate changes. A bond with a duration of 5 years will lose approximately 5% of its value for every 1-percentage-point increase in rates, and gain 5% for a 1-point decrease. Longer-maturity bonds have higher duration and are therefore more volatile. This is why 30-year Treasury bonds move much more dramatically in price than 2-year notes when the Fed adjusts policy — the 30-year yield has fallen from 4.91% to 4.70% in February alone, a move that translates to significant price gains for holders of long-duration bonds.

This is a notable shift from 2023-2024, when the yield curve was deeply inverted — with short-term rates exceeding long-term rates — a historically reliable recession warning signal. The normalization of the curve reflects the Fed's rate-cutting campaign and growing market confidence that the economy is navigating a soft landing rather than heading into recession. For bond investors, a normal yield curve means they are once again being compensated for taking on duration risk, making longer-term bonds a more attractive proposition relative to short-term alternatives.

The term premium — the extra yield investors demand for holding longer bonds versus rolling over short-term ones — has also turned positive after years of compression. This normalization is healthy for the bond market and suggests investors are pricing in real uncertainty about the long-term fiscal and inflation outlook rather than simply chasing duration bets.