What is a bond?

A bond is simply a loan taken out by a company, government or organisation. Instead of going to a bank, the borrower (known as the issuer) gets the money from investors who buy its bonds.

In exchange for the capital (the amount borrowed), the issuer pays interest (known as the ‘coupon’), which is the annual interest rate paid on a bond expressed as a percentage of the face value of the bond. The issuer pays the interest at predetermined intervals (usually annually or semi-annually) and returns the principal (again, the original amount borrowed) on the maturity date, ending the loan.

This is why bonds are referred to as fixed income.

Case study

Let’s say a company wants to raise £100,000 and pay it back in five years. The length of time before a bond is paid back in full is referred to as the term, tenor or maturity.

When the bond matures, the company then pays back the £100,000 it was loaned.

During the five-year period, the company also pays the bond holder a coupon at regular intervals. The coupon is essentially an interest payment on the loan.

When the bond is issued, the bond issuer decides on the coupon it will offer. However, most buyers of bonds will rely on credit rating agencies to determine a fair rate.

Coupons vs yields

Using the example of our £100,000 bond, let’s say the coupon is set at £5,000 a year – this represents a yield (effectively the interest rate) of 5%.

That would mean that, over the course of the bond’s five-year lifetime, the bond holder can expect to earn £25,000, as well as being paid back the initial £100,000 investment.

What types of bond are there?

There are two main types of bonds:

Government bonds

Governments issue bonds to support public spending. Developed-market government bonds are generally considered low risk as there is a low chance of default.

Corporate bonds

Corporate bonds are issued by companies to raise funds. They generally offer a higher yield than government bonds as companies have a higher chance of defaulting.

Corporate bonds can either be rated as:

• Investment grade, which means the bonds have been issued by a company with a good credit rating, indicating that it is less likely to default (not repay the bond).
• Non-investment grade bonds, also known as high-yield or junk bonds: these are typically issued by companies with a lower credit rating, meaning there is a higher chance of default. With the greater risk comes the potential for greater reward as these tend to offer a higher yield.

Does the value of a bond change?

Yes. The coupon or yield of a bond you own won’t change (assuming the issuer doesn’t default).

However, if the issuer subsequently issues a bond of the same maturity, but with a higher yield, your bond becomes less attractive to prospective buyers and will be worth less if you want to sell it.

Conversely, if the issuer issues a bond with a lower yield than that of the one you own, your bond becomes more attractive to prospective buyers and will be worth more.

Pros and cons of bonds

Pros

• Regular income
• Typically less volatile than shares
• Diversification – when stockmarkets fall, bonds often rise in value
• Security – coupons are paid before dividends. If a company enters administration, bond holders will be paid before shareholders

Cons

• Bonds tend to deliver much lower returns than shares in the long term
• Risk of capital loss if the issuer defaults
• High sensitivity to movements in interest rates
• When inflation rises, bonds’ fixed coupon payments may not keep up with purchasing power

What are the differences between individual bonds and bond funds?

 Individual bonds

• Investors must select own bonds
• Price fluctuations will be irrelevant if bonds are held to maturity (assuming the issuer doesn’t default)
• Limited access to large parts of the bond market
• Coupon tends to be paid annually or biannually 
• Trading fees incurred when you buy and sell a bond, but no annual management charges
• Specified maturity date

 Bond funds

• Bond selection carried out on behalf of investors
• Price fluctuations of underlying bonds change value of fund on a daily basis
• Full access to the entire bond market
• Income tends to be paid on a quarterly or monthly basis 
• No trading fees, but funds levy an annual management charge
• No maturity date – bond funds tend to operate in perpetuity

What affects the value of bonds?

Interest rates

Central banks set interest rates, or the amount it costs for governments to borrow.

If interest rates rise, so will government bond yields, which pushes down prices.

This has the largest impact on bonds with the longest amount of time to maturity, or ‘duration’.

Sensitivity to interest rates is known as duration risk.

Ratings

The issuers of bonds are assigned credit ratings by agencies, such as Standard & Poor’s and Moody’s.

If an issuer is downgraded, it will have to offer a higher yield to entice buyers and the value of existing bonds will fall.

Market conditions

If stockmarkets are doing well, investors are more likely to move their money into shares.

If stockmarkets fall or there are unexpected political events or natural disasters, investors may seek safety in the bond market.

Time until maturity

The closer a bond gets to its maturity, the closer it will get to its initial price.