Bonds & Fixed Income

Investing Fundamentals

Chapter 7 · Bonds & Fixed Income

Chapter 2 introduced bonds — a loan with a fixed coupon, and UK Gilts as the real government version. This chapter goes deeper into how a bond's own price actually moves, why it moves that way, and how real credit ratings and duration change the risk picture entirely.

Coupon vs. Yield: Two Genuinely Different Numbers

A bond's coupon — Chapter 2's own real £45-a-year example on a £1,000 nominal 4.5% Gilt — is fixed for the life of that bond and never changes. A bond's yield, by contrast, reflects that same fixed coupon relative to whatever the bond currently costs to buy on the open market — and a bond's market price can, and does, move even though its own coupon never does.

The Real, Inverse Price/Yield Relationship

When prevailing interest rates rise, newly issued bonds start offering higher coupons than older bonds already in circulation. An older bond stuck paying its own lower, fixed coupon becomes relatively less attractive — so its market price falls until its yield (coupon relative to that now-lower price) becomes competitive with what new bonds are offering. When rates fall, the reverse happens: older, higher-coupon bonds become relatively more attractive, and their prices rise.

A Real, Dramatic Recent Example

In 2022, the US Federal Reserve raised its own federal funds rate from a near-zero range of 0.00–0.25% in early 2022 to 4.25–4.50% by December 2022 — a real 4.25 percentage-point increase in under a year, one of the most aggressive rate-hiking cycles in recent Federal Reserve history. Existing bonds paying coupons set under the old, near-zero-rate environment suddenly looked far less attractive next to newly issued bonds paying much higher coupons — and bond prices fell accordingly across the market, a real, concrete demonstration of the inverse relationship in action.

Why This Surprises New Investors

Chapter 2 described bonds as generally lower-volatility than stocks — genuinely true on average, but 2022 is a real, honest reminder that "lower volatility" doesn't mean "no volatility." A bond held to maturity still pays its own full, fixed coupon and returns its full nominal value regardless of what happens to its market price along the way — but anyone needing to sell before maturity, during a period like 2022, could face a genuine, real loss.

Credit Ratings: Judging Default Risk

Not every bond issuer is equally likely to actually repay what it owes. Three real agencies — known as the "Big Three" — assess this risk: Moody's (founded 1909, originating from John Moody's own real publication rating railroad bonds), S&P (tracing to 1916), and Fitch (founded 1924). Together they hold roughly 94% of the global ratings business — S&P alone at around 50%, Moody's at 31.7%, and Fitch at 12.5%.

Investment Grade

Rated BBB/Baa or higher (up to AAA/Aaa). Considered genuinely lower default risk — UK Gilts sit firmly here.

Speculative / "Junk"

Rated below BBB/Baa. Real, historically higher default risk, paying a higher coupon to compensate — often restricted for regulated institutions like pension funds.

Duration: How Sensitive a Bond Actually Is

Duration measures how much a bond's own price moves for a given change in interest rates — and it's driven largely by real maturity, the same short/medium/long classification Chapter 2 already introduced for Gilts. A longer-maturity bond generally has a higher duration, meaning its price swings further, in either direction, for the same real interest rate change — which is exactly why long Gilts suffered more than short Gilts during a rate-shock year like 2022.

Government vs. Corporate Bonds

	Government Bonds (e.g. UK Gilts)	Corporate Bonds
Issuer	A national government	A company
Typical credit risk	Very low (for developed economies)	Varies widely — investment grade to junk
Typical yield	Lower	Higher, to compensate for real, added risk

Hands-On Exercises

Exercise 1

Using this chapter's own real 2022 Federal Reserve example, explain in your own words why an existing bond issued in early 2022 (before the rate hikes) would have become less attractive to a new buyer by December 2022, and what would have needed to happen to that bond's market price to make its real yield competitive again.

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Exercise 2

A friend says, "Bonds are supposed to be the safe part of my portfolio, so I was shocked when their value fell in 2022." Using this chapter's own real material, explain in your own words why bonds falling in value during 2022 doesn't actually contradict what Chapter 2 said about them.

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Exercise 3

Explain, in your own words, why a long-maturity Gilt and a short-maturity Gilt would be affected differently by the same real interest rate change described in this chapter, using the concept of duration.

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Chapter 7 Quick Reference

Coupon — fixed for life; yield — coupon relative to current market price, which moves
Inverse relationship — rates up, bond prices down (and vice versa); real 2022 example: US rates rose from 0.00–0.25% to 4.25–4.50% in under a year
Big Three credit rating agencies — Moody's (1909), S&P (1916), Fitch (1924); ~94% combined market share; BBB/Baa+ = investment grade, below = "junk"
Duration — how sensitive a bond's price is to rate changes; generally rises with longer maturity
Government bonds (e.g. Gilts) — lower risk, lower yield; corporate bonds — varies, generally higher yield to compensate for real added risk