Bonds: What They Are and How They Work
A bond is a type of debt investment. When an investor buys a bond, they are generally lending money to the bond issuer under specified terms. The issuer may be a government, company or another eligible organisation.
What Is a Bond?
Bonds are commonly used by organisations and governments to raise money. In exchange for providing capital, the investor may receive interest payments according to the bond's terms and may receive the principal amount at maturity, subject to the issuer's ability to meet its obligations.
A bond generally represents money lent by an investor to an issuer under defined terms that may include interest payments and repayment of principal.
How Do Bonds Work?
When a bond is issued, its terms generally specify important details such as the principal amount, interest or coupon terms, maturity date and other conditions.
The bondholder provides capital to the issuer. In return, the issuer may make scheduled interest payments and repay the principal according to the terms of the bond.
An organisation may issue a bond with a defined maturity period and interest terms. An investor purchasing that bond is generally providing funds to the issuer. The actual payments and risks depend on the bond's specific terms and the issuer's financial position.
Key Bond Terms
- Issuer: The government, company or organisation borrowing money.
- Principal or face value: The amount associated with the bond's stated value.
- Coupon: The interest payment terms associated with the bond.
- Maturity: The date when the bond's principal is generally due to be repaid under its terms.
- Yield: A measure related to the return associated with the bond's price and expected payments.
Different Types of Bonds
Bond categories can vary depending on the issuer and market. Examples may include:
- Government bonds.
- Corporate bonds.
- Municipal or local government bonds where applicable.
- Short-term and long-term bonds.
- Investment-grade and lower-rated bonds.
Bond Prices and Interest Rates
Bond prices can change in the market. Interest rate movements are one factor that can influence bond prices.
In general, changes in prevailing interest rates can affect the attractiveness of existing bonds compared with newly issued bonds. However, the relationship can depend on maturity, coupon terms, credit quality and other factors.
Potential Risks of Bonds
Bonds are not risk-free simply because they involve lending money. Important risks can include:
- Interest-rate risk: Changes in interest rates can affect market prices.
- Credit risk: The issuer may be unable to make expected payments.
- Inflation risk: Rising prices may reduce the purchasing power of future payments.
- Liquidity risk: It may not always be easy to sell a bond at a desired price.
- Market risk: Bond values can change because of broader market conditions.
Bonds and Investment Portfolios
Bonds may play different roles within an investment portfolio depending on an investor's goals, time horizon, risk tolerance and other holdings.
However, the presence of bonds in a portfolio does not guarantee positive returns or protection from all losses.
Questions to Consider
- Who is the bond issuer?
- What are the interest or coupon terms?
- When does the bond mature?
- What credit and default risks are involved?
- How sensitive may the bond be to interest-rate changes?
- How liquid is the investment?
- How does it fit within the overall portfolio and financial goals?
Key Takeaways
- A bond generally represents money lent to an issuer.
- Issuers may include governments, companies and other organisations.
- Bonds may provide interest payments according to their stated terms.
- Principal repayment and payments depend on the bond's terms and issuer's ability to meet obligations.
- Bond prices can change because of interest rates, credit conditions and other factors.
- Bonds can involve risk, including the possible loss of principal.