Bonds: what are they and how do they work?

June 2025 by Mario Pires

If you're thinking about investing or simply keeping an eye on financial matters, you've surely heard of bonds. Do you know what they are?

A bond is, essentially, a loan. The buyer is lending money to an entity – usually a government or a company – for an agreed-upon period. In return, you receive interest (called coupons) that are paid periodically (once a year, for example) and, at the end of the term (maturity), the amount borrowed is repaid.

The issuer of the bond (the issuer) takes on a kind of debt instrument, committing to repay the amount borrowed along with interest.

In addition to being loans, bonds are also traded on financial markets, which makes them more complex: It is possible to buy and sell them before maturity, and prices may vary depending on investors' expectations or economic and monetary conditions.

Bonds: prices and variations

Price fluctuations in the market can be related to several factors, such as:

• Expectations/changes in interest rates;
• Inflation expectations;
• Global economic conditions;
• Issuer risk level.

Imagine that Maria subscribed to bonds with interest of 3.5% per year, for 3 years. If, after a year, the European Central Bank lowers the interest rate to 2.5% (which becomes the benchmark for new bonds and deposits), your bonds will be attractive. If she decides to sell them, Maria could raise their price by adjusting the cost/yield ratio of her bonds. 

In this regard, the price of a bond in the market corresponds to the value that investors are willing to pay for it at a given time and does not have to coincide with its nominal value.

Risk and reward

Compared to other assets, such as stocks, bonds are more stable and safe investments, since the price tends to vary less and the income tends to be more predictable. In more uncertain situations, some obligations are even considered a “safe haven.”

In the case of government obligations (also called treasury bonds) the fact that they are guaranteed by the State reduces the risk of failure to pay (risk of default). This risk is normally very low, particularly in so-called developed countries. 

In the case of corporate obligations, the relative risk is also lower than in stocks. The worst-case scenario is that the issuer goes bankrupt, but even then, any assets that exist at the time will be used to pay bondholders (creditors) first and then shareholders.

The security of an obligation depends, to a large extent, on the economic and financial situation of the issuer (its reputation), and there are financial rating agencies (such as Moody's, S&P Global, or Fitch) that can help with this assessment.

These agencies analyze different indicators (from debt, profits, and exposure to economic risks in companies, to foreign exchange reserves and trade balances in governments), and the rating they assign to issuers helps assess their risk of default. These ratings are divided into two risk indicator categories: 

• Investment grade, for issuers with high solvency (low risk); 
• Speculative grade, for issuers with higher risk.

A higher level of risk is usually associated with the promise of a higher return (higher interest). This happens, for example, with so-called high-yield bonds.

An indicator that can support the assessment of this risk/return relationship is the spread, as it helps to understand the additional risk of buying a bond that is not seen as safe, compared to another (with the same term) that is considered risk-free, such as German or U.S. treasury bonds. 

The higher the spread, the higher the perception of risk. To compensate for the additional risk, investors will demand that the bond be priced lower in order to obtain a higher effective yield.

Although they may be more complex than they appear at first glance, bonds are essential instruments for those looking to multiply their income, diversifying investment sources and obtaining a relatively stable return. Although they are not risk-free, understanding what they are and how they work allows you to make more informed and safe decisions. 

This was the first step in understanding what obligations are, but you can learn more by seeking advice from those who know.