A bond is a fixed-income instrument which, in its simplest form, can be thought of like an ‘IOU’ between a borrower and a lender - although, in reality, there is a lot more to it than just that. In this article, we will explore bonds in detail, explaining what they are, how they work and much more!
Table of Contents
What Is a Bond?
A bond represents a loan made by the bond’s purchaser to the bond’s issuer. Essentially, when an investor buys a bond, they are lending money to the issuing party for a fixed period of time in exchange for regular interest payments – known as coupons.
Bonds are issued by governments or corporations when they need to raise capital for a specific purpose. Instead of borrowing the entire sum from one source – which, for the amount of money sometimes required by large organisations, is not always possible – they turn to the bond markets, where many different investors take on the role of lender.
How Do Bonds Work?
As we have already seen, when governments or corporations need to raise capital, they often issue bonds.
The borrowing entity creates and issues their bonds directly to investors in the primary capital market, determining the rate of interest that will be paid and the date at which they undertake to repay the loan in full – the maturity date.
A lot of the time, the price at which the bond is originally sold – the issue price – will be the same as its repayment amount – the principal. Nevertheless, sometimes bond issuers will issue bonds at a “discount”, meaning that the issue price is lower than the bond’s principal.
Once issued, the bond’s interest rate does not change, remaining constant throughout the bond’s term. However, some bonds are “inflation-linked”, which means that the repayment amount rises in line with inflation, making these types of bonds more appealing in inflationary environments.
Once issued, the majority of bonds, but not all of them, can be bought and sold among investors in the secondary capital market, meaning that the original bondholder does not have to hold the bond until maturity.
A bond’s market value is determined by factors such as:
- Its interest rate compared with the base interest rate at that point in time;
- The creditworthiness of its issuer; and
- The time remaining until its maturity.
Advantages and Disadvantages of Bonds
As with any investment, investing in bonds comes with both advantages and disadvantages.
Advantages of Bonds
- Bonds offer investors the opportunity to earn regular income on their investment, which can be especially appealing when base interest rates are low.
- They are generally perceived as a lower risk investment when compared with other assets such as stocks. However, this largely depends on the bond issuer.
- If the market value of a bond increases, it can be resold on the secondary market for a profit.
Disadvantages of Bonds
- As mentioned in the advantages, bonds are often considered low-risk. However, investors shouldn’t make the mistake of thinking all bonds are low-risk. Defaults can, and do, happen. Investors should be particularly wary of bonds with a long duration and high interest rate, or bonds which have been issued by entities with a poor credit rating.
- The potential return on bonds is capped at a much lower level than that of stocks.
- Unlike stocks, bondholders have no voting rights and, therefore, cannot have their voices heard in relation to the running of the issuing entity.
- Their market value can go down as well as up, meaning that if bondholders need to sell their bonds before maturity, they may be forced to do so at a loss.
As you may have noticed throughout the article, the bond market has a lot of specific terminology, which can be hard to keep track of. So, before we finish, we have summarised a few of the key terms here to help you out!
Final Thoughts
We hope that you have enjoyed our beginners guide to bonds and have a better understanding of how the bond market works.
Bonds can be a valuable part of an investor’s portfolio, providing additional income and potentially offsetting some of the volatility which can be caused by owning stocks. However, those considering investing in bonds, must not fall into the trap of thinking that bonds are risk-free and should do their due diligence on the issuing entity before purchasing.
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