A bond is a type of IOU issued by a government, local authority or company to raise money.
When governments or large companies want to borrow money, they can do so by issuing bonds to investors. Sovereign bonds are issued by governments, while one from a company is a corporate bond.
The bond issuer receives a loan from the bond investors, on which it must pay interest at set intervals – typically annually or semi-annually. The annual rate of interest is known as the coupon. This is normally fixed for the life of the bond, and so the bond market is also known as the fixed-income market. The amount borrowed – known as the principal – must usually be repaid on a specified date (the maturity date).
Bonds are typically tradeable instruments, so the investors can then sell them on to other people. A bond is issued with a face value (or a par value) – eg, £100 – and this is the amount that all holders will get paid at maturity. But the market price of the bond will fluctuate, and may be less or more than par value.
Bond investors tend to think in yields rather than prices. The “current yield” is the coupon as a percentage of the price. So if our bond pays 5% interest (£5 a year) and the market price is £105, the current yield is 4.76%. The “yield to maturity” is the return for an investor who holds the bond until it matures. While our bond sells for £105, when it matures it will return its par value of £100 – so the yield to maturity here is less than the current yield. How much less depends on when it matures – if that’s in six months, rather than six years, the difference will be greater.
A highly trusted nation – eg, the US – or a highly rated company – such as Apple – will be able to pay a low coupon. Less reliable nations, such as Argentina, or small firms will pay more.
Rising interest rates are bad for bond prices. As the rates available elsewhere go up, yields on existing bonds must rise to compete, so their prices must fall. Inflation is also a problem because the coupon and principal is usually fixed, so inflation erodes their real value.