What Are Bonds? - Lending Your Money as an Investment

A bond is a security issued by a government or corporation to borrow money from investors. By purchasing a bond, you lend money to the issuer and receive periodic interest payments (coupons) in return. At maturity (the redemption date), the face value is repaid. While buying stocks means acquiring partial ownership of a company, buying bonds means lending money in exchange for interest.

For further reading, books on interest rates and bond prices can help you understand the mechanism by which rate changes move bond valuations.

Major bond types include government bonds issued by national governments, municipal bonds by local authorities, corporate bonds by companies, and foreign bonds issued by overseas governments or corporations. Generally, the higher the issuer's creditworthiness, the lower the yield, and vice versa. Japanese government bonds carry low yields precisely because the Japanese government's credit standing is high.

The Inverse Relationship Between Interest Rates and Bond Prices

One of the most important concepts in bond investing is the inverse relationship between interest rates and bond prices. When market rates rise, existing bond prices fall; when rates decline, bond prices rise. This happens because higher prevailing rates make newly issued bonds more attractive, reducing demand for older bonds with lower coupons.

For example, suppose you hold a bond with a face value of 100 man-yen paying a 1% annual coupon. If market rates rise to 2%, new bonds offer 2% coupons. No one would pay face value for a 1% bond, so its price drops below par. Conversely, if rates fall to 0.5%, the 1% coupon becomes attractive and the bond's price rises above par.

How Bonds and Stocks Move Differently

Bonds and stocks generally exhibit different price behavior. During economic downturns, stocks tend to fall as corporate earnings decline, while bond prices tend to rise on expectations of central bank rate cuts. Historical data shows the correlation coefficient between developed-market government bonds and equities fluctuates between roughly -0.2 and 0.3 - not perfectly inverse, but sufficient for meaningful diversification.

  • Equities: High return, high risk. Long-term expected return is around 5-7% per year, but annual declines of 30% or more are possible.
  • Government bonds: Low return, low risk. Expected return is around 0.5-3% per year, with much smaller price swings than equities.
  • Corporate bonds: Intermediate characteristics. A credit spread (additional yield) compensates for default risk, offering higher yields than government bonds.

The Role of Bonds in a Portfolio

The primary reason to include bonds in a portfolio is risk reduction. Adding bonds to an all-equity portfolio dampens overall volatility (standard deviation). A 60% equity / 40% bond portfolio, for example, sacrifices only a modest amount of return while substantially lowering risk.

For individual investors looking for an easy entry point, Japan's Individual Government Bonds (Kojin-muke Kokusai) are a solid choice. The 10-year variable-rate type adjusts its coupon every six months and guarantees a minimum rate of 0.05%. It can be purchased from 1 man-yen and redeemed after one year. For higher yields, bond index funds or ETFs that diversify across domestic and foreign bonds are also available. Try our simulator to compare expected returns under different equity-bond allocation ratios.

Books on stock-bond diversification can help you see, in concrete numbers, the benefits of combining equities and bonds.