The basics of bonds

You may have heard a lot about bonds and their yields recently, but not actually understood the basics around them. Bonds can be tricky to understand at first, so this article is designed as an introduction to help you understand what bonds are and some of their key characteristics.

Think of a bond as a loan

A bond is simply a type of loan. If you want to borrow some money you might go to a bank. However, when Governments and very large companies want to borrow money, they can’t go to a bank because of the huge amounts of money involved. So, a bond is the mechanism by which a Government or large corporation borrows money for their needs. They issue a bond. The bond is issued for a set period of time. Bonds can be purchased for different lengths of time from short-term, medium-term, and long-term bonds. Short-term bonds are only for a year or two, medium-term bonds are up to 10 years, and long-term bonds are generally 10 years or longer, Argentina even has a 100-year bond. At the end of the set period, the bond is said to reach its maturity. At this point, the face value paid for the bond is paid back by the issuer (the issuer is the government or company that borrowed the money in the first place). During the lifetime of the bond, the lender will receive regular interest payments in return for lending the money. These interest payments are paid bi-annually and they are fixed when you initially purchase the bond. So, for example, if you purchased a UK bond (Gilt) for 1000 GBP with a coupon of 5% you would receive a total of £50 for each year of the bond and then receive the 1000GBP back when the bond expires. Government bonds are called ‘gilts’ in the UK and ‘treasuries’ in the US. Company issues bonds and they are called ‘corporate bonds’.

Bonds can be traded after they have been bought.

Once a bond is issued, the bond itself can be bought and sold by other traders. When a bond is bought or sold after its original issue, the face value is still paid to whoever happens to own the bond at its maturity date.

Different quality of bonds

Not all bonds are of the same quality. Bonds from 1st world countries like the US and the UK are seen as more secure than bonds from 2nd and 3rd world countries. The UK for example has never defaulted on its debt, so a UK bond is seen as a very safe and stable investment. In a similar way, a large and stable company will be seen as a more stable bond issuer than a brand new start-up company. As a general rule, the more stable the government or company the lower interest they pay on the bond’s coupon. Conversely, a more ‘risky’ Government or company will issue a higher rate of interest to incentivise investors seeking higher returns. The quality of Government bonds are rated by credit rating agencies like Moody’s, Fitch, or Standard and Poor’s. They give a grade which is an assessment of the creditworthiness of the government issuing the bond. The highest rating given for bonds is the AAA rating. These represent the highest quality grade of bonds. Governments issuing these bonds are considered to be very stable and highly unlikely to default on their payments. The level of the bond decreases from this grade in incremental steps until it reaches the lowest investment-grade bond of or BBB. Anything below this BBB level is considered to be a ‘junk’ bond and highly speculative.

Bond’s relationship to interest rates

One key relationship to grasp is that the value of bonds typically falls when interest rates rise. So, the longer the bond has until maturity, the greater the risk of fluctuation in its price. A one-hundred-year bond could have huge changes in its price before it is finally set to mature.

Finally, the confusing element about bonds

One of the most confusing elements about bonds is that when the price of the bond falls, the yield of the bond increases. In contrast, when the price of the bond rises, the yield falls. So make sure you spend some time grasping this relationship – rising bond yields is a falling bond price and vice versa.

Terminology:

Issuer: the Government or corporation borrowing the money by issuing the bond
Coupon: the interest rate paid on the bond (paid bi-annually)
Fixed interest: the interest paid on the bond
Bond maturity: the end of the bond period and the re-payment of its face value
Par value: the original price paid for the bond
Above par: the price of the bond is above its original price
Below par: the price of the bond is below its original price
Current yield: The bond’s interest expressed as a percentage of the bond’s current price. This is calculated in the following way: coupon/yield = current yield