Bond

What a bond means

A bond is a loan that you make to a government, a public body or a company, in exchange for a promise of repayment. The borrower is called the issuer. It agrees to pay interest, known as the coupon, at regular intervals, and to return the original amount, known as the face value, principal or par value, on a fixed date called maturity. Because the payments are set in advance, bonds are called fixed-income securities.

Bonds exist in many forms. Government bonds, such as those issued by national treasuries, are generally seen as the lowest credit risk within their own currency. Corporate bonds pay more because the company could fail to repay. Municipal and agency bonds sit in between. Some bonds are inflation-linked, some pay floating rates, and some can be converted into shares. Maturities range from a few months to several decades.

Investors use bonds for income, to diversify a portfolio built mostly of shares, to match future liabilities, or to hold something less volatile than equities. Retail investors usually buy bonds through a broker, through an ETF or fund that holds many of them, or directly from a government in an auction or savings programme.

How it works

At issue, a bond has four main terms.

1. Face value, often 1,000 in the bond's currency.
2. Coupon rate, the annual interest as a percentage of face value.
3. Coupon frequency, commonly once or twice a year.
4. Maturity date, when the face value is repaid.

After issue, the bond trades in the secondary market. Its price moves with two drivers. The first is the general level of interest rates. If new bonds start paying more than yours, buyers will only pay less for your older, lower-coupon bond, so its price falls. If rates fall, your bond's fixed coupon looks better and its price rises. The second driver is credit quality. If investors worry that the issuer may not repay, they demand a higher return and the price drops.

Duration is a common measure of how sensitive a bond's price is to rate changes. Longer maturities and lower coupons generally mean greater sensitivity. A bond held to maturity pays the face value regardless of interim price swings, provided the issuer does not default.

A worked example

These numbers are illustrative. An investor buys a 5-year bond with a face value of 1,000, a 4 percent annual coupon, at par.

• Coupon each year = 1,000 × 4% = 40.
• Over five years the investor receives 5 × 40 = 200 in interest, plus 1,000 at maturity, a total of 1,200.

Two years later, new 3-year bonds from similar issuers pay 6 percent. Nobody will pay 1,000 for a bond paying only 40 a year when 60 is available, so the price of the existing bond falls, perhaps to about 950.

• The investor who sells now takes a loss of 1,000 − 950 = 50 per bond, on top of the 80 in coupons already received.
• A buyer at 950 receives 40 per year and 1,000 at maturity. The 50 gain on repayment adds to the yield.
• If the first investor simply holds to maturity, they receive 1,000 and are not affected by the mark-to-market drop, apart from the opportunity cost of lower interest.

Why it matters

Bonds are one of the largest asset classes and anchor the pricing of many other things, including mortgages, corporate borrowing and the discount rates used to value shares. Government bond yields serve as a benchmark for what a low-risk benchmark return looks like in each currency, and changes in them often move currencies and equity markets.

For individuals, bonds can reduce overall portfolio swings, since they often do not move in the same way as shares, though this is not guaranteed. In some years, rising rates have hurt both. Taxes, fees and minimum purchase sizes also vary by country and broker. Bond markets are often over-the-counter, meaning prices are quoted by dealers, so spreads can be wider than on popular shares, especially for smaller issues.

How to use it in practice

• Identify the issuer, the coupon, the currency, the maturity and the credit rating before buying.
• Compare the yield, not just the coupon, since the price you pay may differ from face value.
• Check call features. Some bonds allow the issuer to repay early, which can cap gains.
• Think about duration relative to your time horizon.
• Review the bid-ask spread and any commission your broker charges on bond trades.
• Consider a bond ETF or fund for broad exposure, noting that these have no fixed maturity date.
• Look at how coupon income is taxed in your country.

Common mistakes and misconceptions

• Believing bonds are safe. They have interest rate risk, inflation risk and credit risk, and prices can fall sharply.
• Confusing coupon with yield. The coupon is fixed at issue. The yield changes with price.
• Ignoring inflation, which reduces the real value of fixed payments.
• Assuming a high yield is a bargain. It often signals higher default risk.
• Thinking a bond fund behaves like a single bond held to maturity. A fund has no maturity and its price can stay lower for a long time.
• Overlooking liquidity. Some bonds are hard to sell at a fair price quickly.

Risks and limitations

Issuers can default, in which case investors may recover only part of their money or nothing. Rising rates reduce prices of existing bonds. Inflation erodes returns, and foreign-currency bonds add exchange rate risk. Credit ratings are opinions that can lag events. Government deposit-style protection does not apply to bonds in the way it does to bank deposits. Rules on access, taxation and investor protection differ by jurisdiction, and this article is educational, not individual advice.

How Brokeli looks at it

When we research brokers, we record whether bonds can be bought directly or only via funds and ETFs, which markets and currencies are covered, and what commissions and spreads apply. We keep this tied to the published research snapshot for each country, since availability for bonds can differ more than for shares.