Too embarrassed to ask: what is a bond?

When thinking of investing many people automatically think of the stockmarket. But there is another market – the bond market. So what exactly is a bond?

A bond is just an IOU. When governments or large companies want to borrow money, they often do so by issuing bonds, which are bought by investors.

For example, say the UK government needs to borrow a certain sum of money over a period of ten years. The government would issue a ten-year government bond. In the case of the UK government, this is known as a “gilt”. If it was the US government, it would be a “Treasury”.

The bond has a “face value” or “par value” – that’s the amount of money the UK government will pay the holder of the bond when the bond “matures” in ten years’ time. The bond also has a “coupon”. That’s the annual amount of interest the government will pay the bondholder. This “coupon” payment is usually fixed, which is why the bond market is also known as the “fixed income” market.

So far, so good. Bondholders get annual interest, plus their money back at the end of the loan period. Here’s where it gets a bit trickier: bonds can also be traded. So they are IOUs, but they can be bought and sold. This means that the price of the bond can go up and down, even although its “face value” stays the same.

How does that work? Let’s take an easy example. Say we have a UK government bond that was issued a while ago. When it originally came out, it paid a £5 coupon every year, on a face value of £100.

The thing is, 5% is a very attractive interest rate these days. Today, an investor would be willing to pay significantly more than £100 for an investment that paid out £5 a year for taking almost no risk. So the market price for this bond might be a lot higher than £100. In turn, the interest rate – or “yield” – on the bond would be lower than 5%.

A highly trusted nation such as the US, or a highly rated company such as Apple will be able to offer a low coupon, because it has a high credit rating. Less reliable nations, such as Argentina, or small, riskier firms, will pay more.

For more on the factors that affect bond investors, subscribe to MoneyWeek magazine.

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