Understanding bonds

The below is designed to offer a basic understanding of the bond market.

A bond is effectively an ‘IOU’ issued by either a government or corporation. By investing in a bond, you are essentially lending money to one of these entities. In return for the investment, the issuer delivers an agreed level of income in the form of a fixed rate of interest (coupon). At an agreed date, the government or corporation will return the face value (issue price) of the bond, known as the maturity value.

Bonds can be bought at any time, not just on the day of issue, through the fixed-interest market. In the fixed interest market, the price of a bond may actually be more or less than its original issue price or ‘face value’ and you may lose all of the money invested.

Types of bonds

Government bonds
The Government Bond market is the largest fixed-income market in the UK. The US Treasury Bond market is the largest in the world and is guaranteed by the US Government. In Germany the Government Bonds are called Bundesrepublikanleihe, or Bunds, and the French Government issues OATS.

Corporate bonds
Corporate bonds are debt obligations or IOUs issued by private and public corporations. Companies use the funds they raise from selling bonds for a variety of purposes, for example expanding the business.

A bond issued in a currency other than the currency of the country or market in which it is issued. Eurobonds give issuers the flexibility to choose the country in which to offer their bond according to the country’s regulatory constraints.

High yield bonds
Bonds with a rating of BB (S&P) or Ba (Moody’s) or below are speculative investments. They are called High Yield Bonds or Junk Bonds and are considered highly volatile, but can potentially offer more growth. Such bonds are typically issued by start-up companies, companies that have had financial problems or those who are in a particularly competitive or volatile market.

What factors affect the price of bonds?

Interest rates
Interest rates constantly change in response to supply and demand of credit, fiscal policy, exchange rates, economic conditions, market sentiment and changes in expectations about inflation. As they change, so do bond prices.

The interest rate paid to bondholders is fixed at a rate determined on issue. Consequently, if inflation rises, the ‘income’ received from the bond actually becomes worth less, as goods and services become more expensive.

Inflation is one of the most influential forces on interest rates. Rising inflation often leads to rising interest rates, which reduce bond prices. Conversely, deflation would result in a lowering of interest rates, which would increase the price of bonds.