A bond is a formal contract to repay borrowed money with interest with a floating rate of interest.
It is in essence, a certificate stating that the owner has lent money to a borrower, which will be returned at a specific date.
Bonds, like shares, can be bought and sold but unlike shares, they guarantee a percentage return, agreed at the point of investing.
How often do I receive interest?
A bondholder will receive regular interest – usually half yearly or annually.
Unlike with investment tied to Stocks and Shares, which can often sound exciting, the term ‘Bonds’ is somewhat archaic and as such can put a lot of people off using them, but for many serious investors, it makes sense for a part of their portfolio to be invested in bonds, due to their inherent security.
How do bonds work?
There are several parts to bonds, including:
Face Value/Par Value
This is the amount of money a holder will receive when the bond matures. A newly issued bond will sell for the ‘par value’. A corporate bond will usually have a par value of £1000 or $1000, but a government bond can have a much greater value.
Coupon (The Interest Rate)
This is the amount the bondholder will receive in interest. It is called a ‘coupon’ as sometimes there can be physical coupons on the bond to tear off and redeem for the interest payments.
This is a somewhat old-fashioned method, and it is more likely that the coupons are stored on computer nowadays.
Most bonds pay twice a year, but sometimes they can pay quarterly or monthly. The coupon is shown as a percentage, 10% for example, would pay 10% of the par value in interest per year.
The maturity is the period of time that must expire before the initial investment is repaid.
Timeframes can range from 30 days to 100 years. A bond which matures in 1 year is much more predictable and less of a risk than one which matures in 10 or 20 years – thus, the longer the time before maturity, the higher the interest rate.
The issuer of a bond is a crucial factor to take into consideration, as they ultimately are the ones responsible for returning your initial investment.
The ‘bond rating’ system helps investors assess a companies credit risk, and therefore the risk associated with their bonds. A government bond is classed as a risk-free investment, as the government will always be able to pay out. Conversely, a small company will have a low rating, as its future stability is hard to predict. Often blue-chip firms are seen as safe investments and have thus warrant a high rating.
It is important to say that not that not all bonds are safer than stocks, some types of bond can be just as unpredictable if linked to a company in financial instability.
Yield is the figure that illustrates the overall return you get on a bond. This is different from the percentage rate aforementioned.
With a Bond costing £1000 (with a 10% coupon), the yield is 10%, however if the value of the bond drops to £800, the yield goes up to 12.5%, as you are still receiving the £100 interest on the asset which is now worth £200 less than originally.