When governments or big companies want to borrow money, they can do so by issuing bonds. Bonds are simply IOUs. A corporate bond is an IOU from a company, and a sovereign bond is an IOU from a government. Like any IOU, the bond has two key components: the amount of interest it pays each year (also known as the “coupon”), and the date on which the original loan (the “principal” or “par value”) will be repaid. This is the “maturity date”. Most bonds pay a fixed amount of interest, and thus the bond market is also known as the “fixed income” market.
A bond is typically issued with a par value of £100. However, once it is publicly traded, its price will fluctuate.
A lender who is a very good credit risk will be able to borrow at a low rate. So a highly trusted nation – the US or Germany, say – or a highly rated company – such as Apple – will be able to pay a low coupon. Less creditworthy nations such as Argentina, or small companies, will have to pay a higher coupon to attract lenders.
When people refer to bonds they normally talk about the yield, rather than the price. You will also see different measures of yield quoted. The “current yield” is simply the coupon as a percentage of the price. So if the bond pays out £5 a year and the price of the bond is £105, the current yield is 4.76%.
But remember that when a bond matures, it repays its “par value”. In this example, while the bond sells for £105, when it matures it will only return £100. This shows why maturity dates matter – if it matures in six months, rather than six years from now, then the return the investor gets will be very different. The “yield to maturity” describes the yield an investor will get if they buy the bond today and then hold it until it matures.
All else being equal, rising interest rates and inflation are bad for bonds. That’s because as the rates available elsewhere rise, bond yields have to rise to compete – which means that bond prices have to fall.