At their most basic, bonds are loans. When you buy a bond, you become a lender to an institution. Your loan lasts a certain period of time—until the date when the bond reaches maturity—and you get a certain dividend payment each month (commonly known as a coupon) as interest on the loan. As long as the institution does not go bankrupt, it will also pay back the principal on the bond, but no more than the principal.
Two forces govern the performance of bonds and bond funds: interest rate sensitivity and credit risk.
Interest Rate Risk
The higher a bond's duration (measured in years), the more it responds to changes in interest rates. If a bond has a duration of five years, you can expect it to gain 5% if interest rates fall by one percentage point, and to lose 5% if interest rates rise by one percentage point. So a bond with a duration of four years should be twice as volatile as a bond with a duration of two years.
All other things being equal, the lower a bond's credit quality, the higher its yield. Because higher-grade issuers are more likely to meet their obligations, investors trade greater certainty for higher income.
Credit quality affects more than just a bond's yield, though; it can also affect its performance. High-yield bond funds usually take a hit when investors are worried about the economy, as recessions usually mean lower corporate profits and thus less money to pay bondholders.
Related Reading Buying Bonds
Introduction to Government Bonds
Examining a Bond Fund's Portfolio, Part 1
Examining a Bond Fund's Portfolio, Part 2
Choosing a Municipal-Bond Fund
Short-Term Municipal Bond Funds
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