What are bonds and how do they work?
The bond market is larger in value than the global stock market, and is one of the most traded financial assets in the world. Learn more about where bonds are and how they work.
What is a bond?
A bond is a type of loan where the bondholder lends money to a company or government. The borrower pays regular interest until a set date in the future, after which they pay back the original loan amount.
This final amount paid back by the bond issuer to the bondholder is called the "principal" and the interest is a series of payments called "coupons."
The capital can also be called the value or par value of the bond. Coupons are paid at set intervals (ie semi-annually, annually, or in some cases, monthly) and are a percentage of the initial payment. The amount for the coupons is often fixed, but in the same way, as for index-linked bonds, these can vary as the bond adjusts its payments to follow an index - such as the inflation rate.
Because bonds are generally negotiable securities, they can be bought and sold like stocks on a secondary market. However, there are some important differences between these two. Many bonds are listed on markets such as the London Stock Exchange (LSE), but they are primarily traded over the counter (ITC) through institutional brokers.
Just like stocks, bond prices are sensitive to various market forces, such as supply and demand. This means that investors can make money if the asset increases in value, or lose money if a bond they sell has decreased in value. Since a bond is a debt instrument, its price is highly dependent on interest rates.
As interest rates rise, bonds become less attractive to investors who could profit from the high-interest rates elsewhere, and prices fall. When interest rates fall, bonds become more attractive and prices rise.
What types of bonds are there?
There are a large variety of bonds. In practice, bonds are often defined by who sells them – governments, corporations, municipalities, and governmental organizations. When there is a need to raise money for an investment or to support existing expenses, the seller can obtain better interest rates and terms in the bond market than those offered by other credit channels, such as banks. Where Is The Serial Number On A Savings Bond?
Government bonds
In the UK, government bonds are referred to as 'gilts'. In the US they are called "Treasuries". All investments involve risk, but government bonds from established and stable economies are generally considered to carry
low risk.
American "Treasury bills" (or T-bills) are bonds with a maturity of one year or less. "Treasury notes" (T-notes) have a maturity of between two and ten years. "Treasury bonds" (T-bonds) have maturities of 30 years.
While most UK and US government bonds have a fixed interest rate, there are also varieties that vary the coupon payments based on inflation. In the UK these are called "Index-linked gilts", and in the US they are called "treasury inflation-protected securities" (TIPS).
Corporate bonds
Corporate bonds are sold by companies to obtain financing for investments. High-quality bonds from well-established companies can be seen as a conservative investment, but they still involve more risk than a government bond, and pay out higher interest rates.
When you buy a corporate bond, you become a lender and get more protection from losses than shareholders. If the company is liquidated, bondholders are compensated before shareholders. Corporate bonds are evaluated by organizations such as Standard & Poor's, Moody's, and Fitch Ratings.
Municipal bonds
Municipal bonds are used by local authorities (such as councils, municipalities, cities, or districts) to finance local infrastructure projects. In England, they are issued by the UK Municipal Bonds Agency (UK MBA).
They are considered, just like government bonds, to involve a low risk and offer a relatively low-interest rate. In the United States, municipal bonds may be exempt from certain taxes at both the local, state, and federal levels.
Agency bonds
These are primarily located in the United States and are securities offered by either government-sponsored enterprises (GSEs) or non-Treasury agencies. Treasuries are guaranteed by the US government, but GSE bonds are not. Well-known GSE bonds include those of the National Mortgage Association ("Fannie Mae") and the Federal Home Loan Mortgage ("Freddie Mac").
How do bonds work?
Bonds are debt instruments. The bondholder lends money to the issuer, who then repays the loan in the manner described in the bond. Often the issuer regularly makes a series of fixed interest payments - coupons. The principal payment of the loan is made last, when the term of the bond expires.
However, there are variations on this pattern, such as zero-coupon bonds and index-linked "gilts".
- Zero-coupon bonds: these make no coupon payments Instead, the interest on the bond is the difference between the bond's price and the principal (or value). For example, if you bought the bond for SEK 9,500 and received its value of SEK 10,000 at maturity, you earned 5.26% in interest.
- Index-linked bonds: these vary their coupon payments based on changes in the rate of inflation. Although the changes in these coupon payments are calculated differently, the US equivalent is "Treasury Inflation-Protected Securities" (TIPS)
Characteristics of bonds
Maturity and duration
A bond must specify both its term (or term) and duration. These two are very different. A bond's maturity date means the day on which its term expires and the last payment is made - i.e. its active life.
Duration specifies two important characteristics of the bond. The "Macaulay duration" is the time it takes for a bond to pay back its value and is expressed in years. This is converted into the bond's "modified duration" – a measure of its price sensitivity to changes in interest rates. The longer the maturity of a bond, the more its price will fluctuate with movements in interest rates.
Credit rating
Credit rating agencies such as Standard & Poor's, Moody's, and Fitch assess the creditworthiness of bond issuers, which gives market participants important insight into the bond's credit risk. This is important both for the issuers and potential buyers.
The buyer needs to know if the issuer can pay the coupons and principal consistently and on time. The issuer can also use the assessment to price their bonds in a way that attracts investors.
The lower the issuer's credit risk - or the higher their rating - the lower they can set their coupon payments, reducing the cost of borrowing. The higher the issuer's credit risk, the higher their payouts will need to be to attract investors.
To use Fitch Ratings' scale as an example, the lowest-risk long-term bond is given an AAA rating, while inferior bonds (or "junk bonds") start at BB+.
