Bond Investing:How Fixed Income Works

In the previous stage of the investment journey, we discovered how to generate income through BDCs and private credit. We will now turn to an asset class with a different logic, often less visible but central to financial markets: bonds.

Unlike stocks, bonds are not based on ownership of a company, but on lending capital. This gives them a particular profile, positioned between seeking income and managing risk, with a direct link to the interest-rate environment.

What are bonds?

When you buy a bond, you do not acquire part of a company as you do with a stock. You lend it money for a defined period in exchange for interest.

Bonds form part of the fixed-income market. Governments and companies use them to finance their activities, projects or liquidity needs.

How do bonds work?

The way a bond works is relatively simple.

The investor lends capital to the issuer for a defined period and, in return, receives regular interest payments called coupons.

You lend capital

→

You receive coupons

→

You recover the face value

On the maturity date, the issuer repays the bond’s face value, provided it meets its payment obligations.

A simple example: if you buy a five-year US Treasury bond with a 4% coupon, you will receive the corresponding interest throughout its life and recover its face value at maturity.

Types of bond

There are different types of bond depending on the issuer, term and level of risk. It is important to understand these differences because each category can play a distinct role in an investment strategy.

Sovereign bonds

Corporate bonds

Municipal bonds

Sovereign or government bonds

They are issued by national governments to finance public spending and other state needs. Their level of risk depends on the issuing country, although sovereign debt from developed economies with high credit quality is generally considered one of the safest options in the bond market.

In the United States, Treasury securities are divided into several categories according to their maturity:

Treasury Bills (T-Bills)

They mature within one year and do not pay regular coupons. The return comes from buying them at a discount and receiving their face value at maturity.

Treasury Notes (T-Notes)

They mature in two to ten years and pay interest every six months. They offer an intermediate point between short- and long-term instruments.

Treasury Bonds (T-Bonds)

They mature after more than ten years and also pay interest every six months. Because of their long duration, they are generally more sensitive to changes in interest rates.

Corporate bonds

They are issued by companies to finance their operations, investments or expansion.

They generally offer a higher yield than high-quality government bonds because they involve greater credit risk. Their level of risk depends directly on the financial ability of the issuing company to meet its commitments.

Municipal bonds

They are issued by regional governments, cities or other local public bodies.

Depending on the country and the investor’s tax situation, some may offer particular tax advantages.

Essential concepts for analysing a bond

Before analysing a bond, you need to understand the elements that determine how it works, its return and its level of risk.

Basic bond elements

Face value

This is the amount the issuer promises to repay at maturity and serves as the basis for calculating the coupon. The bond’s price may vary in the market, but its face value remains fixed.

Coupon

This is the interest paid by the bond on its face value. For example, a bond with a 5% coupon pays USD 5 per year for every USD 100 of face value.

Price

This is the value at which the bond is bought or sold in the market. It may be below, equal to or above its face value.

Maturity date

This is the date on which the issuer must repay the bond’s face value.

Yield

Current Yield

This relates the bond’s annual interest payments to its current market price. It shows the income generated relative to the price paid, but does not account for the gain or loss that may occur at maturity.

Yield to Maturity (YTM)

This represents the estimated total return if you buy the bond at its current price and hold it until maturity. It takes into account the coupons, purchase price and face value you will receive at the end.

Main risks

Credit risk

This is the risk that the issuer cannot pay the interest or repay the principal. It can be assessed partly through credit ratings assigned by agencies such as Moody’s, S&P Global Ratings or Fitch.

Interest-rate risk

When market rates change, the price of existing bonds may also vary. We will examine this relationship in greater detail in the next section.

Duration and sensitivity

The longer a bond’s duration, the more sensitive it generally is to interest-rate changes. For this reason, long-term bonds may experience larger price movements than short-term bonds.

Callable bonds

Some bonds allow the issuer to repay the capital before maturity. This usually occurs when rates fall and the issuer can refinance on better terms, which can limit the investor’s expected return.

Why does a bond’s price change?

Even when a bond provides for defined payments and a specific maturity, its price can vary throughout its life. These changes depend mainly on interest rates, inflation and perceptions of the issuer’s risk.

Face value and market price

As we have seen, face value is the amount the issuer will repay at maturity. Once issued, however, the bond can be bought and sold on the secondary market at a different price.

Its price may be:

Below par · 95

At par · 100

Above par · 105

If you hold the bond until maturity and the issuer meets its obligations, intermediate price movements become less important. As maturity approaches, the price tends to converge towards the face value.

The inverse relationship between interest rates and price

The policy rates set by central banks, such as the US Federal Reserve (Fed) or European Central Bank (ECB), influence the yields available in the market.

When rates rise, new bonds tend to offer higher yields. Existing bonds with less attractive coupons must fall in price to offer a competitive yield.

When rates fall, the opposite occurs: existing bonds offering higher coupons become more attractive and their price tends to rise.

This is one of the fundamental relationships to remember:

Interest rates ↑ → Bond prices ↓

Interest rates ↓ → Bond prices ↑

The role of inflation

Inflation reduces the purchasing power of money and particularly affects bonds that pay fixed interest.

For example, if a bond offers an annual return of 5% and inflation reaches 6%, the nominal return remains positive, but the investor loses purchasing power in real terms.

When inflation expectations rise, investors generally demand higher yields to compensate for this loss of purchasing power. This can put downward pressure on the prices of existing bonds.

Central banks may also raise interest rates to contain inflation, which reinforces this effect in the bond market.

Corporate bonds and credit risk

For corporate bonds, another factor is important: the financial condition of the issuing company.

If investors believe a company is at greater risk of having difficulty repaying its debt, they will demand a higher yield to accept that risk and the price of its bonds may fall.

Conversely, if the company improves its financial condition, reduces its debt or strengthens its repayment capacity, perceived risk may fall and its bonds may rise in value.

The price of a corporate bond therefore depends on both the general interest-rate environment and the issuer’s credit quality.

The role of fixed income within a portfolio

At Scale & Own, we primarily favour government bonds because of their higher level of safety and predictability. This type of bond generally plays a more defensive role in an investment portfolio.

Its purpose is not to maximise returns, but to provide stability and protect capital alongside other assets that are more exposed to risk.

Advantages of investing in bonds

Predictable income

They allow you to know the interest payments and maturity date in advance.

Lower volatility

High-quality bonds generally experience smaller fluctuations than stocks.

Diversification

They can help balance a portfolio dominated by stocks.

Liquidity

Many bonds can be resold on the secondary market before maturity.

Disadvantages and risks

More limited return potential

They generally offer less growth potential than stocks.

Credit risk

The issuer may have difficulty meeting its commitments.

Interest-rate risk

An increase in rates can reduce the price of existing bonds.

Variable liquidity

Not every bond can be bought and sold as easily on the secondary market.

Who might find bonds suitable?

Less risk

Investors seeking to reduce portfolio risk

Bonds can help reduce the volatility of a portfolio dominated by stocks and provide greater stability.

Income

Investors seeking income and capital preservation

Once a certain level of wealth has been reached, bonds make it possible to structure relatively predictable income streams. For example, USD 1 million invested in government bonds offering a 4% annual yield would generate approximately USD 40,000 per year before tax.

For a person with substantial wealth, low risk tolerance and a priority of preserving capital and generating income, high-quality bonds could even represent most or all of the portfolio.

Retirement

Investors approaching retirement

As the investment horizon shortens, the priority may gradually shift from growth to capital preservation. In this context, bonds can provide greater stability and reduce exposure to stock-market fluctuations.

Bonds can also generate capital gains

Although bonds are used primarily to generate income through interest and provide stability, they can also produce capital gains.

This happens particularly when interest rates fall. In this environment, existing bonds offering higher coupons may become more attractive and rise in value on the secondary market.

For example, the price of a bond bought when market yields were 4.5% could rise if comparable bonds subsequently offered yields closer to 3%.

It may then be possible to sell the bond before maturity at a capital gain, although its price may also move in the opposite direction when market conditions change.

How do you invest in bonds?

One accessible way to invest directly in bonds is through an international broker such as Interactive Brokers, which provides access to different fixed-income markets.

Although the bond market may appear complex at first, the buying process becomes much simpler once you understand the concepts we have just covered.

In this section, we will see step by step how to buy US Treasury securities through Interactive Brokers, in line with the defensive approach we favour at Scale & Own.

Once you have logged in to your Interactive Brokers account, open the platform’s “Bond Scanner” section.

There, you can view and filter the available fixed-income instruments.

The platform allows you to filter by asset type:

• Government bonds, such as US Treasury securities.
• Corporate bonds, issued by companies.
• Municipal bonds, issued by local bodies.

As Scale & Own primarily favours high-quality sovereign debt, we will select “US Treasuries” in this example.

You will find several categories among US Treasury securities:

• Bill: short term (up to one year) and no coupon.
• Note: medium term (two to ten years) with interest payments every six months.
• Bond: long term (more than ten years) and greater sensitivity to changes in interest rates.
• TIPS: bonds whose principal value is adjusted for inflation.
• STRIPS: instruments with no coupon, bought at a discount and particularly sensitive to interest-rate changes.

In our example, if you are looking for a US Treasury security with a horizon of around five years, you should select a Treasury Note.

You can then apply filters such as:

• A maturity date close to your investment horizon.
• A minimum Yield to Worst that corresponds to the yield you are seeking.

For a horizon of around five years, you could, for example, look for maturities around 2031 and set a minimum Yield to Worst of 3.5%.

It may also be useful to consult the Fed’s current policy rate to better understand the macroeconomic environment in which you are buying bonds.

After applying the filters in Interactive Brokers, a list of results will appear. Do not be intimidated by the figures: you only need to validate these four essential points.

Confirm the asset type (Product)

Following the approach in this tutorial, look for a US-T Govt Note, which means a standard US Treasury Note with a medium-term maturity of two to ten years.

Check that it is not a TIPS, STRIPS or another type of instrument covered in the previous step.

Check the maturity date

The maturity date should correspond to your investment horizon.

If you want to invest for around five years, look for maturities close to 2031.

For example:

Nov15’31 → 15 November 2031

Whenever possible, choose a maturity that is consistent with when you plan to recover this capital to use or reinvest it.

The key difference: coupon and yield

• Coupon (for example, 1.375%): the fixed interest calculated on the bond’s face value. It determines the regular payments the investor will receive.
• Current Yield: the annual interest received relative to the bond’s current purchase price. If you buy a bond at a discount, this yield may be higher than the coupon.
• Total return, or Yield to Maturity (YTM), for example 3.80%: the estimated annualised total return if you hold the bond until maturity, taking into account:
  • The purchase price.
  • The interest received.
  • The final repayment of the face value.

Important rule: YTM allows you to compare the estimated total return of different bonds through to maturity. If your goal is to generate cash flow, however, you must also pay attention to the coupon and Current Yield because they more closely reflect the regular income you will receive.

A bond can therefore have a 1.375% coupon and a 3.80% YTM without paying you 3.80% per year in cash.

In the next point, we will see how the purchase price explains this difference.

Analyse the bond price

The bond price tells you whether you are buying:

At a discount · below 100

At par · around 100

At a premium · above 100

Price below 100

Imagine that you buy a bond at a price of 87.

During the life of the bond, you will receive its coupons. If you hold it until maturity and the issuer meets its commitments, you will receive 100 in face value.

Your return then comes from two sources:

• The coupons received.
• The difference between the 87 paid and the 100 received at maturity.

This explains why a bond with a 1.375% coupon can offer a YTM close to 3.80%.

Price above 100

If you buy a bond above 100, the opposite happens.

For example, a bond with a 4.5% coupon may generate higher regular cash flow. But if you buy it above 100, you will receive only 100 in face value at maturity.

Its YTM may therefore be lower than its coupon percentage.

The difference to remember is simple

Coupon = interest received regularly. YTM = estimated total return to maturity.

Summary: which bond should you choose from the list?

Product	Coupon	Yield	How is the return mainly distributed?
US-T Govt Note 4.5 Dec’31	4.5%	3.79%	Higher regular cash flow + purchase at a premium
US-T Govt Note 1.375 Nov’31	1.375%	3.80%	Lower cash flow + purchase at a discount
US-T Govt Note STRIPS	0%	3.82%	No regular cash flow + purchase at a discount

As you can see, these bonds offer a very similar yield, but distribute their return in very different ways.

If your main goal is to generate cash flow, pay close attention to the coupon and Current Yield. If you want to compare the total return through to maturity, YTM provides a more complete reference.

Once you have identified the bond you want to buy, click its name to open its detailed information page.

There, you can check the bond’s main characteristics before proceeding with the purchase.

Scroll down to view detailed information about the product.

Check that the data corresponds to the selected bond. If everything is correct, click “Buy” to continue to the purchase order.

If this is your first attempt to trade bonds, Interactive Brokers may ask you to enable fixed-income trading permissions before continuing.

In this case, you will need to:

• Complete or update your investor profile.
• Answer a short questionnaire about your knowledge and experience.
• Request permission to trade bonds.

Once the request has been submitted, permissions are generally granted within 24 to 48 hours. When they are active, you can return to the selected bond and continue with the purchase order.

After selecting the bond, you can enter the quantity you want to buy and prepare the order.

For many US bonds, each unit represents a face value of USD 1,000. However, the price shown on the screen is generally expressed as a percentage of that face value.

For example:

• A price of 102.092 is equivalent to approximately USD 1,020.92 for each USD 1,000 of face value.
• If you buy 10 bonds, the purchase price will be approximately USD 10,209 before accrued interest and any commissions are added.

Before submitting the order, click “Preview”.

Interactive Brokers will display the estimated cost of the transaction. Check in particular:

• The purchase amount.
• Commissions.
• Accrued Interest.
• The estimated total cost.

Accrued interest is the portion of the next coupon that has already accumulated since the last interest payment. When you buy a bond between two payment dates, this amount is paid to the seller and added to the transaction cost.

After checking all the data, you can click “Buy Order” to submit the order.

Once the order has been executed, the bond will appear in your Interactive Brokers portfolio.

Conclusion and the next step with Scale & Own

If you have reached this point, congratulations.

The bond market is generally neither the most intuitive nor the most appealing at first glance. However, you have just understood one of the most important foundations of the financial system.

Understanding how bonds work and their relationship with interest rates, inflation and yields allows you to develop a much stronger view of investing and understand the general behaviour of financial markets more clearly.

Bonds also have a particular place in a portfolio. They can generate income, but their role goes beyond cash flow: they can also provide greater stability, preserve capital and reduce exposure to risk.

Next stage: growing your capital

On the next page, we will return to stocks, but from a different perspective.

This time, the main objective will not be to generate income through dividends, but to grow our capital over the long term by seeking quality companies with growth potential whose share price is below their intrinsic value.

Continue to the next stage: Quality at a fair price

→

• What are bonds?
• How do bonds work?
• Types of bond
• Concepts for analysing bonds
• Bond prices
• The role of bonds in a portfolio
• How to invest in bonds
• Next stage with Scale & Own