Fixed Income Fundamentals: Bonds, Coupons, Duration, and Credit Risk

Fixed income securities represent debt instruments that provide investors with a fixed series of cash flows over a specified period.

The most common form is the bond, which consists of three key components:

• The nominal value of the bond, which the issuer agrees to repay at maturity.
• Typically issued in standard denominations (e.g., $1,000 per bond for US Treasuries).
• The principal value is critical for calculating coupon payments and serves as the basis for interest calculations.
• In the case of zero-coupon bonds, there are no periodic interest payments; instead, the bond is sold at a discount to face value and redeemed at full face value at maturity.

• Fixed-rate bonds pay a constant coupon amount throughout their life, making them predictable income sources.
• Floating-rate bonds (also known as variable-rate bonds) have coupons tied to an index (e.g., LIBOR, SOFR, US Treasury rates), causing payments to fluctuate.
• Step-up and step-down bonds have coupon rates that change at predefined intervals, providing structured cash flows.

Types of Fixed Income Securities

Government bonds: Government bonds are considered the safest, backed by the full faith and credit of national governments. Examples include US Treasuries, UK Gilts, Chinese Sovereign Bonds, and the European Union’s Green Bonds. These sovereign bonds are graded based on the issuing government’s creditworthiness, with developed economies generally receiving higher credit ratings.

Corporate bonds: Corporate bonds are issued by private and public corporations to raise capital. They are categorized as either investment grade or high yield, depending on their credit ratings. In 2025, green corporate bonds account for approximately 15% of the total global corporate bond market, with major issuers like Apple, Microsoft, and Tesla leveraging these instruments to fund renewable energy, energy efficiency, and other sustainability initiatives.

Municipal bonds: Municipal bonds are issued by state and local governments, often carrying tax advantages for investors. These bonds are increasingly used to finance environmentally focused projects, such as California Green Municipal Bonds for wildfire mitigation.

Asset-backed securities (ABS): Asset-backed securities (ABS) represent another class of fixed income, where bonds are collateralized by pools of underlying assets. In 2025, green ABS are becoming more common, backed by renewable energy loans, electric vehicle financing, and sustainable agricultural investments.

Duration and Interest Rate Sensitivity

Duration: Duration is a critical measure of a bond's sensitivity to interest rate changes, expressed in years. It captures the weighted average time an investor must wait to receive all cash flows from a bond. For example, a bond with a duration of five years means that, on average, the investor will recover their invested capital in five years, adjusted for the time value of money. Duration also indicates price sensitivity: a bond with a duration of ten years will lose approximately 10% of its value for every 1% increase in interest rates.

Convexity: Convexity accounts for the non-linear relationship between bond prices and interest rates. Bonds with positive convexity, such as standard government and corporate bonds, gain more value when rates fall than they lose when rates rise. Conversely, bonds with negative convexity, such as callable bonds, behave differently because the issuer can redeem them early, limiting price appreciation.

Interest rate risk in 2025: As of May 2025, interest rate risk is a significant concern for bond investors. The Federal Reserve maintains a cautious approach to rate hikes, with US inflation stabilizing around 4%, while the Eurozone sees inflation at 3.2%. Long-duration bonds, such as 30-year US Treasuries, are experiencing significant price fluctuations as market expectations for future interest rate changes shift.

Credit Risk in Fixed Income

Credit rating agencies: Credit risk is the possibility that a bond issuer will default on interest or principal payments, directly affecting the bond’s value. Credit rating agencies, including Moody’s, S&P, and Fitch, assess the creditworthiness of issuers and assign ratings that reflect default risk. These agencies evaluate multiple factors, including an issuer’s financial health, revenue stability, debt levels, and, increasingly, environmental, social, and governance (ESG) risks. As of 2025, ESG factors are fully integrated into credit assessments, with issuers in high-risk sectors, such as energy and heavy industry, facing greater scrutiny. For instance, a company heavily reliant on fossil fuels without a credible decarbonization strategy may see its credit rating downgraded, reflecting heightened transition risk.

Investment grade vs. high yield: Bonds are categorized by their credit quality, which significantly influences their risk and return profile. Investment-grade bonds are rated BBB- or higher (S&P and Fitch) or Baa3 or higher (Moody’s), indicating a relatively low risk of default. These bonds are favored by conservative investors, including pension funds and insurance companies, due to their perceived safety. In contrast, high-yield bonds, also known as junk bonds, are rated below investment grade. These bonds offer higher yields to compensate investors for taking on greater risk. As of 2025, the high-yield market has experienced increased volatility due to rising interest rates, which have strained issuers with lower credit quality. The energy sector has been particularly affected, with multiple companies facing downgrades and defaults amid declining fossil fuel demand and stricter regulatory requirements. The consumer discretionary sector has also seen rising defaults, driven by weakening consumer spending and supply chain disruptions.

Default risk: Default risk is the likelihood that a bond issuer will fail to make scheduled interest payments or repay the principal at maturity. This risk is a primary concern for bond investors, particularly in the high-yield market. As of May 2025, global default rates among high-yield bonds are projected to reach 4.3%, reflecting a challenging environment for lower-rated issuers. However, default rates vary significantly by region, with emerging markets experiencing a higher default rate of approximately 6.1%. This regional disparity is driven by factors such as currency volatility, political instability, and weaker legal protections for bondholders. In 2025, several Chinese property developers have defaulted on high-yield debt as the country’s real estate sector faces a prolonged downturn. In the United States, the energy sector has also seen notable defaults, with smaller exploration and production companies struggling to adapt to decarbonization pressures and fluctuating oil prices.

The Evolution of Sustainable Fixed Income Markets: From Green Bonds to Sustainability-Linked Bonds

Origins and growth of sustainable bonds: The sustainable fixed income market began with the issuance of green bonds, first introduced by the European Investment Bank (EIB) in 2007. Sustainable bonds were initially created as a means to fund environmentally beneficial projects, with green bonds serving as the first form of these instruments. The EIB’s green bond issuance set a precedent for sustainable finance, providing a model that was soon adopted by other multilateral institutions and private sector issuers. These early green bonds were limited in scope but demonstrated the viability of aligning financial instruments with sustainability objectives.

Since then, the market has expanded rapidly:

• Global sustainable bond issuance in 2025: Expected to exceed $1.5 trillion, with a growing share of sustainability-linked bonds (SLBs). As of May 2025, global sustainable bond issuance has surpassed $1.5 trillion, driven by strong demand for environmentally and socially responsible investment options. Sustainability-linked bonds (SLBs) now account for a significant portion of this market, reflecting investor interest in bonds that tie financial outcomes to sustainability performance. SLBs are particularly attractive because they offer flexibility, allowing issuers to use proceeds for general purposes while being held accountable to sustainability targets.
• Regional leaders: The European Union remains the largest market for sustainable bonds, followed by the United States and China. The European Union maintains its position as the global leader in sustainable bond issuance, supported by the fully enforced EU Green Bond Standard, which mandates rigorous reporting and external verification. The United States follows as the second-largest market, with strong growth in corporate green and social bonds, including issuances from major technology firms and financial institutions. China ranks third, driven by sovereign green bond issuance and the rapid expansion of corporate sustainable bonds, particularly in the renewable energy and electric vehicle sectors.
• Sectoral trends: Financial institutions, energy companies, and technology firms dominate the sustainable bond market, while sovereign green bonds gain traction in emerging markets (e.g., Brazil, India, South Africa). Financial institutions are the largest issuers of sustainable bonds, leveraging their balance sheets to finance green and social projects. Energy companies, both traditional and renewable, use sustainable bonds to support their transition strategies, including the development of renewable energy capacity and carbon capture technology. Technology firms have become major players in the sustainable bond market, with issuances from companies like Apple, Microsoft, and Google funding energy efficiency and circular economy initiatives. In emerging markets, sovereign green bonds are gaining prominence, with countries like Brazil, India, and South Africa issuing green bonds to fund climate adaptation and sustainable development projects.

Key Sustainable Bond Types:

• Green bonds: Focused on environmental projects, including renewable energy, sustainable agriculture, and water conservation. The EU Green Bond Standard, fully enforced in 2025, mandates rigorous reporting and external verification. Green bonds are specifically issued to finance projects that generate clear environmental benefits. These can include renewable energy generation, sustainable agricultural practices, water conservation, waste management, and clean transportation. The EU Green Bond Standard, which became fully enforceable in 2025, has set a new benchmark for green bond issuance. This standard requires issuers to provide detailed impact reporting, undergo external verification of environmental claims, and ensure that proceeds are used exclusively for eligible green projects. For example, a 2025 green bond issued by the European Investment Bank funds solar energy projects in Southern Europe, with impact reports measuring carbon emissions avoided.
• Sustainability-linked bonds (SLBs): Bonds with variable interest rates linked to issuer sustainability performance targets (SPTs). In 2025, approximately 40% of SLBs include Scope 3 emissions targets. Sustainability-linked bonds (SLBs) are unique because they tie the bond’s financial characteristics, such as interest rates, to the issuer’s sustainability performance. This allows issuers to use bond proceeds for any purpose, but they must achieve predefined sustainability targets to maintain favorable terms. In 2025, SLBs are increasingly incorporating Scope 3 emissions targets) which account for indirect emissions across the value chain (making them a critical tool for driving corporate sustainability. For instance, a 2025 SLB issued by a global energy company includes a target to reduce Scope 3 emissions by 15% within five years, with a penalty clause that increases the bond’s interest rate if the target is missed.
• Social bonds: Fund projects addressing social challenges, such as affordable housing, healthcare access, and education. These bonds account for 15% of total sustainable bond issuance in 2025. Social bonds are issued to finance initiatives that directly benefit society. These can include affordable housing, healthcare services, educational programs, and social inclusion projects. The COVID-19 pandemic accelerated the adoption of social bonds, and their popularity has continued into 2025, with social bonds accounting for 15% of the total sustainable bond market. Governments, non-profits, and international organizations are among the largest issuers. For example, in 2025, the World Bank issued a social bond to fund maternal healthcare programs in Sub-Saharan Africa, with impact reports tracking improvements in maternal survival rates.
• Transition bonds: Issued by high-emission sectors (e.g., oil and gas, mining) to finance decarbonization efforts. However, transition bonds have faced increasing criticism for greenwashing, with new verification standards introduced in 2025. Transition bonds are designed for companies in high-emission industries, such as oil and gas, chemicals, and mining, that are committed to reducing their environmental impact. Unlike green bonds, which fund projects with clear environmental benefits, transition bonds can support activities that are part of a broader decarbonization strategy. However, they have been criticized for enabling greenwashing. In response, new verification standards were introduced in 2025, requiring issuers to provide clear transition plans, measurable environmental targets, and independent verification. For instance, an oil and gas company’s 2025 transition bond funds a carbon capture and storage project, but the company is required to provide annual progress reports verified by a third-party auditor.

Regulatory developments:

• The EU Green Bond Standard (2025) mandates that all EU-issued green bonds must meet stringent environmental criteria and undergo third-party verification.
• The US SEC (Securities and Exchange Commission) has proposed enhanced ESG disclosure rules for all sustainable bond issuers, emphasizing transparency and anti-greenwashing measures.
• The ICMA (International Capital Market Association) has updated the Green Bond Principles and Sustainability-Linked Bond Principles to include specific guidelines for reporting Scope 3 emissions.

Differentiating Conventional Bonds from Sustainable Bonds: Structural, Regulatory, and Market Differences

Structural differences

Use of proceeds:

• Conventional bonds: Issued for general corporate purposes without any restriction on how proceeds are used. Issuers are free to allocate funds toward any business activity, whether for capital expansion, debt refinancing, or operational expenses. These bonds do not require any specific disclosure regarding the use of funds, making them versatile but lacking transparency in how capital is ultimately applied.
• Sustainable bonds: Issued with proceeds specifically allocated to eligible green, social, or sustainable projects, with strict tracking and reporting requirements. These bonds are structured to finance environmentally or socially beneficial initiatives, such as renewable energy, sustainable agriculture, affordable housing, or healthcare access. For instance, an EU Green Bond issued in 2025 must comply with the EU Green Bond Standard, which requires issuers to clearly specify eligible projects, maintain separate accounting for the use of proceeds, and provide detailed impact reporting verified by external auditors.

Performance-linked characteristics:

• Conventional bonds: Fixed or floating interest rates determined at issuance. These rates are based on market conditions, the issuer’s credit rating, and prevailing interest rates. For example, a conventional corporate bond may offer a fixed 5% annual coupon, while a floating-rate bond may pay interest linked to the three-month SOFR (Secured Overnight Financing Rate) plus a fixed margin.
• Sustainability-linked bonds (SLBs): Interest rates may vary based on the issuer's achievement of sustainability performance targets (SPTs), including carbon reduction, renewable energy use, and biodiversity enhancement. For instance, a 2025 SLB issued by a European energy company has a starting coupon of 3%, but this rate increases to 3.5% if the company fails to achieve its target of reducing carbon emissions by 20% within three years. SLBs provide flexibility, allowing issuers to allocate funds for general purposes while holding them accountable for sustainability outcomes.

Regulatory differences

Disclosure requirements:

• Conventional bonds: Standard financial disclosures based on issuer creditworthiness. These include financial statements, credit ratings, and any material risk factors affecting the issuer’s ability to meet its obligations. Investors rely primarily on credit ratings assigned by agencies like Moody’s, S&P, and Fitch.
• Sustainable bonds: Mandatory impact reporting, alignment with recognized principles (e.g., ICMA, EU Taxonomy), and external verification. Issuers must publish detailed reports specifying how proceeds are used, the environmental or social impact achieved, and how these outcomes are measured. For example, under the EU Green Bond Standard, a sustainable bond issuer must provide annual reports on the environmental benefits of financed projects, such as carbon emissions avoided or renewable energy generated. In the United States, the SEC has introduced new ESG disclosure requirements in 2025, mandating that issuers of sustainable bonds provide standardized sustainability data, including third-party verification of impact claims.

Third-party verification:

• Conventional bonds: No requirement for external verification beyond credit ratings. Investors rely on the financial strength of the issuer, as assessed by rating agencies, without any independent review of the bond’s use of proceeds or impact.
• Sustainable bonds: Third-party verification (e.g., ISS ESG, Sustainalytics) is now standard, with new EU and US regulations enforcing independent validation. Verification can include pre-issuance reviews to ensure that the bond’s framework aligns with recognized sustainability principles, as well as post-issuance audits to confirm that funds were allocated to eligible projects and that reported impacts are accurate. In 2025, an increasing number of institutional investors require third-party verified bonds to minimize the risk of greenwashing. For example, a 2025 green bond issued by a major Asian bank is verified by ISS ESG, which confirms that proceeds are used for renewable energy projects and that impact metrics are calculated accurately.

Market dynamics and investor behavior

Investor base:

• Conventional bonds: Attract a broad range of institutional investors, including pension funds, mutual funds, insurance companies, and sovereign wealth funds. These investors are primarily focused on achieving predictable income and preserving capital, relying on the issuer’s credit rating as the main indicator of risk.
• Sustainable bonds: Attract impact investors, sovereign wealth funds, and institutions with explicit ESG mandates. These investors prioritize sustainability outcomes alongside financial returns. For instance, the Norwegian Government Pension Fund, one of the largest sovereign wealth funds in the world, has a policy of actively investing in green and sustainable bonds. In 2025, major asset managers, including BlackRock and Vanguard, have expanded their sustainable fixed income funds, driving demand for high-quality green, social, and sustainability-linked bonds.

Pricing dynamics:

• Conventional bonds: Priced based on credit quality, duration, and macroeconomic conditions. Investors evaluate the issuer’s financial strength, prevailing interest rates, and market demand when determining the bond’s yield. For example, a high-credit-quality corporate bond may offer a yield of 3%, while a lower-rated high-yield bond may offer 8% to compensate for default risk.
• Sustainable bonds: Often priced at a “greenium” (a slight premium), reflecting strong demand for sustainable assets. In 2025, the average greenium is estimated to be around 12 basis points (0.12%), though this premium varies by issuer type and bond structure. Investors are willing to accept slightly lower returns on sustainable bonds due to their positive environmental or social impact and the reputational benefits of holding ESG-compliant assets. For example, in 2025, a green bond issued by a European technology firm offers a yield of 2.75%, while a conventional bond of similar credit quality from the same issuer offers 2.87%. The difference reflects investor preference for sustainable assets.