What is a bond?

19 November 2020 | Posted by Claro Money

So, what are bonds? They’re basically cashing in on IOUs.

What’s it all about?

They are ‘I owe yous’ (IOUs) that companies and governments issue to raise money. Investors lend them money, and in return, they get a regular interest payment.

Why should you care?

They’re great for a diverse portfolio as they tend to move in the opposite direction to stocks and shares. So if your shares go down, bonds can help to balance things out. They also provide a regular fixed income and are considered safer than stocks and shares.

What will you learn?

In this pack, you’ll learn about what bonds are, how they work and what to consider if you want to get in on the action.

What are bonds?

When you invest in a bond, you’re making a loan to an organisation. They promise to pay you back, and in the meantime, they’ll usually give you regular interest payments that are also known as coupons.

Governments issue bonds to fund expenses, infrastructure, military expenses, or to pay back the interest on their existing loans.

For companies, it’s a great way to raise cash and it doesn’t involve issuing new stock and giving up ownership.

What all this means is that institutions usually get to borrow money at lower interest rates than if they borrow money from a bank. And investors usually receive a higher rate than they would get on a cash investment. However, the risk involved is usually higher.

There are short-term bonds of between 1 – 3 years. These are considered to be less risky and you are more likely to get your money back, but you get lower interest rate payments; however, the risks involved are usually different

There are also long-term bonds of over 10 years. These have more risk but higher interest rate payments.

Bonds have risk ratings, like a credit score. For example, government bonds are usually AAA or AA rated. This means they have higher credit ratings and are generally safer investment options than those rated at lower levels, or even some corporate ones.

How do they work?

When an institution issues a bond, they include:

A coupon or coupon rate, which is the interest payment.
A maturity date, which is when the loan or bond principal is due.

For example, you might buy a 10-year bond with a 5% coupon for £100. That means you’ve lent the institution £100 for 10 years. In return, the institution will pay you £5 interest each year until the maturity date, when it’ll give you back your original investment – the £100. So you will have made £50 (5 x 10) on top of your initial £100.

The initial price is sometimes called the ‘face value’, ‘par value’, or ‘nominal value’.

There is a secondary market for some corporate and government bonds. Like stocks, the price goes up and down. Investors can get out before the bond hits maturity, or buy in late. For example, you could sell your £100 bond for £120, or you could find a bond with a £100 face value on sale for £80. If you keep it until the maturity date, you’ll get £100 in addition to the regular interest payments.

Because the price of a bond changes on the secondary market, the coupon rate alone stops being a useful measurement of its value. Instead, look for the bond yield rate, which is the annual coupon payment divided by the market value of the bond.

Let’s look at this with numbers. A bond sold with a face value of £100 that pays £5 a year has an initial coupon value of 5%. If the price of the bond goes up to £120, its yield decreases to 4.2% (5÷120) for the investor that buys it at that price. However, if the price drops to £80, the yield goes up to 6.3%.

You might also see YTM, or “yield to maturity” quoted. YTM is an estimated return of the bond if you hold on to it until the maturity date.

The price typically rises close to the maturity date, because there’s more certainty the face value will be repaid. The price will also increase when the stock market is experiencing difficulties and people are looking for stable investments. Both factors will reduce the yield for the investor.

Higher yield bonds are usually riskier, so please bear this in mind when checking the market.

What to consider when investing in bonds

Like any investment, take into account your personal goals and think about:

Risk – how likely it is you may lose money? You are less likely to lose your money with AAA bonds or shorter-term bonds.
Return – how much money can you potentially make? Generally, the higher the return, the higher the risk.
Liquidity – how soon can you access cash? Will a regular interest payment help meet your needs?
Values-aligned investing – where can you invest your money according to your personal values?

As we have learnt, bonds offer fixed income and return your capital at the end of the term. They offer stability that shares don’t provide. Having a fixed income might be suitable as part of a diverse portfolio mixed with other types of investment, to adjust the overall amount of risk you’re taking.

They’re considered a low-risk investment compared to stocks, and government bonds are almost risk-free as they are usually unlikely to default on their payments, especially countries such as the UK.

Corporate bonds are usually a riskier option than government ones, as companies are more likely to go bankrupt or default on their obligations. Still, if a company is liquidated, bondholders get paid first.

Government bonds are issued all the time, so there are more of them available than corporate ones. In comparison, the market for corporate bonds is often illiquid, meaning there aren’t always many buyers and sellers.

You should also know that bonds are more likely to be affected by inflation and changes in interest rates.

Inflation generally has a negative effect on bonds as it means their coupon payments and maturity repayments reduce in real terms over time. A bond that pays less than the rate of inflation is technically losing you money.

If interest rates set by central banks are higher than the bond yield, then the price will go down to make its yield more attractive on the secondary market. Falling interest rates will have the opposite effect.

Rising interest rates (mean lower prices) = higher yields.

Falling interest rates (mean higher prices) = lower yields.

As with stocks, when it comes to ethical investing, bonds give you a lot of freedom to choose institutions that align with your values.

Where to get bonds

Investing in bonds requires analysis and expertise. This also takes time.

If you’re short on time, using professional companies with the experience to choose the best ones for you can be a good idea.

You could also consider choosing funds which include bond allocations.

Key takeaways

That’s a wrap. Here are the key takeaways from this pack.

Bonds are IOUs that companies and governments issue to raise money.
They’re generally a lower risk investment than stocks. They offer fixed income and return your initial investment at the end of the bond’s term, which can provide the stability you can’t get from stocks.
They give you a lot of freedom to invest in institutions that align with your values, but it’s difficult to get the information you need to make that choice.
Researching and choosing them can be time-consuming, but you can get in on the action by investing in funds that contain them.
Bonds are a great way to diversify your investment portfolio because they usually have a negative correlation with stocks.

When investing, your capital is at risk.

Sign-up & take control