What is a bond?
Bonds are a tried and tested way of investing based on a loan. They’re known for being relatively low-risk. So, are bonds the right kind of investment for you? And how do they work?
What are the key details of a bond?
Bonds are a type of loan. They are issued by governments or corporations when they want to raise money. The issuer will agree to repay the loan's value by a specific date alongside interest payments, usually twice a year.
You can think of a bond as a form of I.O.U – an informal document acknowledging the debt – between a lender and a borrower. This I.O.U will encompass all the important details about the loan and its payments. These usually include the end date, when the principal of the loan that needs to be repaid, plus the terms for variable or fixed interest payments. Here are some key details that explain bonds at a glance:
Bonds are units of corporate debt issued by companies as tradable assets.
Bonds are called fixed-income instruments because they traditionally pay a fixed interest rate to the lender or debtholder.
Variable or floating interest rates have become more common recently
When interest rates rise, bond prices fall and vice-versa. This is called inverse correlation.
Bonds always have a fixed maturity date. This is when the principal must be paid back to avoid defaulting.
How do bonds work?
When governments or other organizations need to raise money, they frequently issue bonds directly to investors. The issuer of a bond is called the borrower. The bond will include the loan terms, interest payments, and the date when the loaned funds – the principal -must be paid back. The interest payment is known as the coupon and is part of the return that bondholders earn for lending their funds to the issuer.
At the start, most bonds are set “at par,” a pre-set face value per individual bond. The actual market price is influenced by several factors, such as the issuer's creditworthiness and the coupon interest rate when compared to the wider interest rate at the time. The face value or at par rate is paid back to the lender once the bond has matured.
As a bond investor, you don’t have to hang on to your bond until the maturity date. You can sell to other investors. You’ll also find that borrowers often repurchase bonds if the interest rate declines or their credit improves, allowing them to reissue bonds at a lower cost.
Who issues bonds?
Governments issue the majority of bonds, but corporations also issue them to raise money. Government-issued bonds tend to be regarded as higher quality because governments are usually more stable than businesses. They can, for example, raise taxes to cover debt if necessary.
What are the different types of bonds?
There are four different categories of bonds, although you may also come across foreign bond types issued by global corporations.
Corporate bonds – these are issued by commercial companies, usually to finance debt. The bond market offers more favorable terms and lower interest rates.
Municipal bonds – states or municipalities issue this type of bond and sometimes offer tax-free coupon income for investors.
Government bonds – there are three different subcategories of government bonds. Those with a year or less until maturity are called “bills.” Bonds with one to ten years until maturity are called “notes.” And bonds issued with more than ten years until maturity are called “bonds.” Together they can all be categorized as “treasuries.”
Agency bonds – organizations connected to the government issue this type of bond.
What are the key bond terms?
The terms surrounding bonds can be a little confusing, so here are some of the main ones you’ll encounter. Which terms are most relevant to you will depend on whether you’re keeping bonds up to maturity or selling them to other investors.
Coupon: this is the interest rate paid by the bond – it usually stays the same once the bond is issued
Face value: this is what the bond is worth when it’s first issued. Bonds usually have a face value or “par” of $1,000
Price: unlike the face value, this is what a bond would cost on the secondary market. Several factors influence this value, the most important being how good the coupon is compared with similar bonds.
Yield: this measure of interest incorporates a bond’s changes in value. The simplest way to measure yield is the bond coupon divided by the currency price.
How do you choose a bond?
There are a few important elements to consider when choosing your best bond options.
Maturity is a major factor. This refers to the length of time you'll have to wait before getting the bond’s face value back. Bonds with longer maturities will be more affected by changes in interest rates—just like if you were paying off a mortgage.
This means that bonds with longer maturities inherently have a higher risk level but generally provide higher yields, so are more attractive to potential buyers. This relationship—between maturity length and yield—is called the yield curve.
The next factor to consider is duration. This is also measured in years and calculated by considering a bond’s current value, yield, coupon, and other relevant features. It’s a good way to assess a bond’s vulnerability to interest rate changes and highlight that bonds with longer durations are the most sensitive.
Bonds are also rated by quality. This is established by assigning a credit rating, which can help you see the likelihood of receiving your expected payments. If a credit rating is low, a bond might have an attractively high yield but a higher risk level. If the rating is high, you can be confident you’ll receive the promised amount. Bonds are rated by agencies such as Standard & Poor (S&P) and Moody’s Investors Service.
Bonds are a well-proven, stable type of investment – especially the government variety – and you can buy them through brokers or many of the main online platforms. But as with all types of investment, it’s a good idea to take expert advice before committing your hard-earned money.
Senior Content Writer
Rachel is a Senior Content Writer at Unbiased. She has nearly a decade of experience writing and producing content across a range of different sectors.