Be the lender, not the owner: how bonds actually work
The answer
A bond is a loan with a certificate attached, and the certificate can be sold to somebody else. You lend money to a government or a company, they promise to pay you a fixed amount every year and return your money on a stated date, and until that date arrives you can sell the promise to another investor at whatever price the market will pay.
Why this costs you money
Most people meet the bond market without knowing it. They put money in a debt mutual fund because an app called it "low risk", or they hold a fixed deposit because a parent held one. Then one of 2 things happens, and both are expensive.
The first is silent. A fixed deposit pays 7%. Inflation runs at 5%. The saver believes they earned 7%. They earned 2%, and after tax on the full 7% they may have earned almost nothing. Ten years of this is a decade of standing still while feeling productive.
The second is loud. In April 2020, investors in 6 Franklin Templeton India debt schemes found they could not take their money out. About ₹25,856 crore was locked. Many had chosen those funds instead of a fixed deposit because the returns were slightly better and the label said "debt". They did not know they had become lenders to companies, and that a lender is not the same thing as a depositor.
The mistake in both cases is identical. People treat fixed income as a category called "safe" instead of as a loan they made, to somebody specific, for a stated period, at a stated rate. Once you know who borrowed your money, for how long, and at what price, the whole thing becomes readable.
How it works
A bond has 4 numbers on it. That is the entire instrument.
Face value. The amount the borrower returns to you at the end. Usually ₹1,000 or ₹100 in India, $1,000 in the United States. Also called principal.
Coupon. The fixed annual payment, stated as a percentage of face value. A ₹1,000 bond with a 7% coupon pays ₹70 a year.
Maturity. The date the face value comes back. Bonds run from a few months to 30 years, and occasionally to 100.
Price. What somebody will pay you for the bond today. This is the only one of the 4 that moves.
Now the part almost every beginner skips. The coupon is fixed. The price is not. So the return a new buyer gets is not the coupon. It is the coupon plus or minus whatever they gain or lose on the price by holding to maturity. That combined number is the yield.
Coupon is what the bond pays. Yield is what you earn if you buy it at today's price and hold it to the end.
If a ₹1,000 bond paying ₹70 a year can be bought today for ₹900, the buyer gets ₹70 on ₹900, plus ₹100 of gain when ₹1,000 comes back. Their yield is well above 7%. The coupon never changed. The entry price did.
There are 2 kinds of borrower. Governments borrow in their own currency and can raise taxes or, in the last resort, create money. Companies can do neither, so a company bond pays a higher coupon. That extra payment is the credit spread, and it is the price of the risk that you do not get your money back.
One fact surprises people. The bond market is larger than the stock market. Global fixed income outstanding was about $145 trillion at the end of 2024, against global stock market value of about $127 trillion. The stock market gets the headlines. The bond market sets the interest rate on your home loan.
What it tells you, and what it does not
Owning a bond tells you the maximum you can earn. If you buy at a yield of 7% and hold to maturity, and the borrower pays, you get 7% a year. A company can triple its profits and your coupon stays at ₹70.
That is the whole trade. A shareholder owns the upside and the downside. A lender has given away the upside for a promise and a place in a queue.
The queue is the part nobody explains. If a company is wound up, the order of payment is fixed by law. Secured lenders first, then unsecured lenders including most bondholders, then preference shareholders, then ordinary shareholders.
So a bond does not tell you the company is good. It tells you that you are ahead of the shareholders if it turns out to be bad. That is worth less than people assume when the company is small and the assets are few.
A bond also does not tell you what you will keep. Inflation, tax and the cost of getting out early all reduce it. A 7% coupon with 5% inflation and tax at your slab rate can be a negative real return. In India that has been the normal case for long periods.
The decision rule
Before you buy any fixed income product, answer 3 questions in order.
1. Who is the borrower? A government, a bank, a large company, or a small company. This sets your credit risk.
2. How long is the loan? This sets your price risk, which article 4 in this cluster covers.
3. What is the yield after inflation and after tax? Not the coupon.
If question 3 gives you a number below zero, you are paying somebody to hold your money. For money you need in 8 months, that is usually right. You should know you are doing it.
If a product offers a yield far above government bonds of the same length, that gap is not a bonus. It is the market's opinion of the borrower.
Try this now
Two minutes, on your own money. This is the most useful calculation in fixed income and almost nobody does it.
- Open the fixed income you actually hold: a debt mutual fund, or a fixed deposit.
- For a debt fund, find the monthly factsheet. Search the fund name plus "factsheet". Find the line called Yield to Maturity, YTM or Portfolio Yield. For a fixed deposit, write down the interest rate.
- Find the latest CPI inflation figure for your country.
- Subtract.
Yield − inflation = your real return before tax. - Now apply tax. Multiply your yield by (1 − your tax rate) before subtracting inflation. For most Indian readers holding a debt fund bought after 1 April 2023, or a fixed deposit, that rate is your income slab rate.
What you should see. For most readers the number after step 4 is between −1% and +2%. After step 5 it is frequently negative. That is the correct answer, not a mistake in your arithmetic.
This does not make fixed income useless. Money you need within 3 years should not be in shares at any price. It means you now know what you are buying: certainty, purchased with return. Now you can see the price of it.
Three real cases
1. Greece, March 2012 — a government bond that did not pay back Greek government bonds were held across Europe as safe assets. In March 2012 Greece restructured its debt in the largest sovereign restructuring in history. Holders of about €197 billion of bonds, roughly 97% of the privately held total, accepted a cut of 53.5% in face value. The bonds paid their coupons for years. Slightly more than half the principal never came back. A government bond is the safest credit in a market. It is not a guarantee.
2. IL&FS, September 2018 (India) — a top-rated borrower defaulting inside weeks Infrastructure Leasing and Financial Services was a large Indian infrastructure lender with group borrowings of roughly ₹1 lakh crore. It held high credit ratings through August 2018. On 17 September 2018, ICRA and CARE cut its ratings to D, the default grade. Debt mutual funds holding IL&FS paper marked those holdings down, and investors who believed they held a cash substitute saw their fund value drop in a single day.
3. Franklin Templeton India, 23 April 2020 — the promise you cannot sell Franklin Templeton wound up 6 debt schemes holding about ₹25,856 crore: Low Duration, Ultra Short Bond, Short Term Income, Credit Risk, Dynamic Accrual and India Income Opportunities. The bonds had not defaulted. In the panic of March and April 2020 there were no buyers for lower-rated Indian corporate paper at any sensible price, and too many investors wanted out at once. Money was returned over several years. A bond is a promise you can sell only if somebody is buying.
The question that resolves it
A novice looks at a fixed income product and asks: what is the return?
An expert asks: who owes me this money, and what happens to me if they cannot pay?
The first question has one number as an answer and the number is advertised. The second has a name, a balance sheet and a position in a queue as its answer, and nobody advertises those.
What would make this wrong
If bonds were genuinely the safe half of the market, holders of government bonds would never lose money. They do, in 2 distinct ways.
They lose to default, which Greece demonstrated in 2012. And they lose to rising interest rates even when every payment is made in full. In 2022 the Bloomberg US Aggregate Bond Index fell about 13%, its worst calendar year since the index began in
- Not one borrower missed a payment.
The honest limit is that "hold to maturity and you get your yield" is only true for a single bond you actually hold to maturity. A debt mutual fund never matures. Treating a bond fund like a bond is the most common and most expensive error in this subject.
In India
Government borrowing comes in 3 forms.
- G-Secs, central government bonds issued by the RBI on the government's behalf, typically 5 to 40 years.
- T-bills, central government borrowing for 91, 182 or 364 days. No coupon. You buy below face value and get face value back.
- SDLs, state development loans, issued by individual states. They usually yield 20 to 40 basis points more than a central government bond of the same maturity
, because states cannot create money and the market prices that.
Company borrowing is issued as debentures, and listed retail issues are called non-convertible debentures, or NCDs. Secured NCDs are backed by specific assets. Unsecured NCDs are not.
A retail investor has 3 routes. RBI Retail Direct, launched in November 2021, is a free account with the RBI for buying G-Secs, SDLs and T-bills at the auctions, with a ₹10,000 minimum. Debt mutual funds are how most Indian retail money actually reaches the bond market. Exchanges and bond platforms carry listed NCDs.
Interest on a fixed deposit is taxed at your income slab rate. Debt fund taxation changed materially in 2023.
In the United States
Government borrowing has 3 names, split purely by original length. Treasury bills run up to 1 year and pay no coupon. Treasury notes run 2 to 10 years. Treasury bonds run 20 and 30 years. There are also TIPS, whose face value rises with the consumer price index. TIPS are the one common instrument that pays a return defined after inflation rather than before it.
Municipal bonds, or munis, are issued by states, cities and public agencies. Their defining feature is tax. Interest on most munis is exempt from federal income tax, and often from state tax for residents of the issuing state. That makes a 3% muni equivalent to a much higher taxable yield for a high earner.
Buying is direct and cheap. TreasuryDirect.gov sells Treasuries straight from the government with a $100 minimum. Brokers sell Treasuries and corporate bonds in the secondary market, and bond ETFs give exposure to thousands of bonds in one trade.
Where they differ, and what that tells you
The instruments are similar. The route retail money takes is completely different, and that changes what you should watch.
An American retail investor typically owns bonds directly — a Treasury from TreasuryDirect, or a bond ETF whose holdings are published daily. They know their maturity date. If prices fall, they can wait, and the face value arrives on the stated day.
An Indian retail investor typically owns bonds through a debt mutual fund. The fund has no maturity date. You leave at whatever the units are worth.
The Indian corporate bond market makes this worse. Total Indian corporate bonds outstanding are roughly $600 billion, against a US market many times larger, and most Indian corporate bonds barely trade after issue. A fund holding them can mark a price without being able to sell at it. That is what closed the Franklin Templeton schemes in April 2020.
What that tells you is specific. An American should focus on interest rate risk, because they can hold to maturity and largely ignore price. An Indian in a debt fund cannot ignore price, because price is all they will ever receive. It also means Indian readers have one option almost nobody uses: RBI Retail Direct buys the actual bond, with an actual maturity date, and turns a price problem into a waiting problem.
Carry this
- A bond is a loan you can sell. The coupon is fixed, the price is not, and the yield is what the 2 make together.
- Always answer: who is the borrower, for how long, and what is left after inflation and tax.
- A single bond matures. A bond fund never does. That difference is the whole risk.