In his latest video tutorial, MoneyWeek’s deputy editor Tim Bennett explains the basics of bonds – what they are and how they work.
A bond is a type of IOU issued by a government, local authority or company to raise money. If, for example, a company wants to borrow money for ten years at a time when investors expect a 5% yield, it must offer a £5-a-year interest for every £100 until the bond matures (this payment is known as the coupon). However, expected yields are constantly changing. If interest rates rise to 10%, a new investor won’t be willing to pay £100 for an annual return of £5 when he can get £10 elsewhere.
He will expect a minimum 10% on his initial outlay, so the price of the bond will have to fall to £50 to reflect that. So, at a time when interest rates are going up, bond investors are seeing the value of their asset drop. On the other hand, if interest rates fall, a bond’s price will rise.
• Entry from MoneyWeek’s Financial glossary.