How does the bond market work?

How does the bond market work?

A natural complement to stocks in an investment portfolio, bonds are based on very different principles.

February 19th, 2026

If you have a diversified portfolio, it likely contains some stocks, perhaps in the form of a mutual fund composed of Canadian, U.S. or international equities, and some bonds, perhaps in the form of a bond fund. It’s also possible that you own a balanced fund that combines these two components. In each of these cases, the “bond” portion of your portfolio has some very specific characteristics.

Here’s what you need to know.

The bond: a debt security

A bond is essentially a loan from an investor to a government, public institution or corporation. In return for this loan, the borrower issues a debt security – the bond – that represents a commitment to make regular interest payments and to repay the initial investment on a set maturity date.

Because it’s a loan, a bond is a debt security. And because it provides regular interest payments, it is also known as a “fixed income security.”

Diagram entitled “What is a bond?”, with the subtitle “In brief.” Icons and arrows are used to explain the workings of a bond. On the left, an icon representing an investor is linked by an arrow to an icon of a bag of money labelled “Principal”, and then to an icon of a building representing the issuer. The issuer is identified as potentially being a government, a municipality, an institution or a corporation. The diagram shows that the investor lends money to the issuer. In return, an arrow indicates that the issuer makes regular interest payments, known as “coupons,” to the investor. These are represented by several dollar signs. At the bottom of the diagram, another arrow indicates that when the bond matures, the issuer returns the principal to the investor. As a whole, the diagram provides a simplified illustration of the flow of money between the investor and the issuer in the context of a bond investment.

A bond is different from a share

So a bond is very different from a share (or stock), which is an “equity security”: when you buy shares of a company, you become a part owner of that company. The company’s only commitment is to allow you to share in the gains if its value grows (which means that you could also experience losses). Some companies also pay dividends, but these are not guaranteed. 

Table entitled “How is a bond different from a share?”, with the subtitle “A few points of comparison.” The image presents a table comparing a share and a bond. The left column is labelled “Share” and the right column is labelled “Bond.” Under “Type of investment,” the share is described as an ownership security, where the holder owns part of the company, while the bond is described as being a debt security, where the holder is a company creditor. In the section labelled “Characteristics,” the “Share” column indicates that the holder may benefit from the growth of invested capital, may sometimes receive dividends, and has no guarantee with regard to performance or the return of the principal investment. The “Bond” column specifies that the holder may receive a regular fixed income, that the investment value may fluctuate over time in response to changing interest rates, and is assured of getting the principal back at maturity. As a whole, the table highlights the basic differences between shares and bonds in terms of the type of investment, income and guarantees.

For all these reasons, bonds are considered to be a lower-risk investment than stocks; on the other hand, the potential returns are also lower. However, it’s important to realize that, even though repayment of the principal at maturity is guaranteed, the value of a bond may still fluctuate over time.

How is that possible?

How bond values fluctuate before maturity

The reason is that once a bond has been issued, it can be bought and sold by investors on the financial markets. 

As with everything that can be traded, bonds are subject to the law of supply and demand.

Let’s say that an investor holds a $10,000 bond with an interest rate of 4.00%. If equivalent bonds issued more recently are only paying 2.00%, a bond that pays twice the rate becomes very attractive: other investorswould be willing to pay more than $10,000 for it to improve their potential yield. On the other hand, if interest rates go up, the bond becomes less attractive and holders wishing to sell would have to accept less than what they paid for it.

That is the fundamental rule of the bond market: the value of outstanding bonds generally tends to rise as interest rates fall, and fall as interest rates rise. 

Graph entitled “How bond values fluctuate,” with the subtitle “In response to interest rates.” The image illustrates the inverse relationship between interest rates and bond prices by means of two comparative diagrams. On the left, a diagram shows that when interest rates go down, represented by a downward arrow beside a percent sign, bond prices go up, represented by an upward arrow beside a dollar sign. The relationship is illustrated by a seesaw tilted up at the end representing bond prices. On the right, a second diagram shows the opposite effect: when interest rates go up, represented by an upward arrow beside a percent sign, bond prices go down, indicated by a downward arrow and a dollar sign. This time the seesaw is tilted down at the end representing bond prices. As a whole, the diagram provides a visual and symmetrical representation of the fact that bond prices move in an inverse relationship to interest rates.

A broad and complex market

The bond market is a major component of the financial markets. On a global scale, its capitalization outstrips that of the stock market, notably due to governments’ massive use of debt financing. 

It is a complex market used primarily by large institutional investors such as pension plans. These investors work to optimize the performance of their portfolios by buying and selling securities based on their reading of what will happen to interest rates in the short, medium and long term. They also keep track of numerous other factors, such as yield spreads, i.e., the difference between the rates offered by issuers considered to be safe and the higher rates offered by issuers with a higher risk profile.

For the retail investor

Retail investors aren’t usually directly active on the bond market, but participate through mutual funds that are invested in bonds. For a minimal outlay, these funds provide a diversified, professionally managed bond portfolio, or even a portfolio pegged to a benchmark bond index. Without excluding the possibility of temporary ups and downs in response to interest rate movements, such funds offer the potential for a performance outlook consistent with the goal of long-term wealth preservation.

Your advisor can give you more information about this topic and help you to incorporate this asset class into your portfolio in a way that reflects your specific goals.

The following sources were used to prepare this article:

AMF, “Investir dans les obligations.”

AMFIE, “Understanding non-complex bonds.”

Carmignac, “Demystifying bonds in a matter of minutes.” 

CFI, “Bonds”; “Active Bond Portfolio Management.”

Get Smarter About Money, “How bonds work.”

Investopedia, “Yield Spread: Definition, How It Works, and Types of Spreads.”

POSB, “101 of investing in Bonds.” 

PUPrime, “What Are Bonds And How Do They Work.”