A bond is a financial instrument which operates as a guarantee by the borrower to repay money to a lender, typically accompanied by interest. In simple terms it is an IOU.
The bond market includes the debt of governments - known as treasuries in the US and gilts in the UK - and debt issued by companies as corporate bonds.
Because the majority of bonds offer a fixed rate of interest over a set period of time they are often known as 'fixed-income' securities. On maturity the bondholder gets their money back - the principal - and this is usually 100% of the face amount.
EXPLAINING THE COUPON
The payments from a bond are also called the coupon and are more or less guaranteed unless the issuer goes bust. Should a company face insolvency, bondholders are ahead of equity holders in the queue to get money back.
There is an explicit schedule for the coupon, which is typically paid once or twice a year, and this offers a degree of security which does not exist with company dividend payments.
A company can pass or cut a dividend at its leisure - the worst consequence being a hit to the share price, a protest by investors and negative coverage in the media - but if the issuer of a bond misses a single coupon payment it would be in default and the value of the bond would collapse.
HOW TO ASSESS A BOND
Weighing up whether or not to buy a bond essentially means considering the creditworthiness of the issuing company. The longer-dated an instrument the more risk attached to investing in it. This holds true in the bond market and is usually reflected in the higher coupon paid on the 10-year UK gilt against the two-year.
A key element of bonds which is not fixed is their market price. Investors can buy and sell bonds and are able to sell them before they reach maturity. They are therefore not 'locked in' for the full lifetime of the bond as long as there is a willing buyer.
The return from a bond investment is made up of both the interest paid and capital gains from movements in the price. If the yield on a bond goes up then the market price must be falling and vice versa.
The yardstick most widely used to capture the return on a bond is the yield to maturity (YTM) which looks to capture the capital gain or loss associated with the bond through to redemption.
The three key elements to consider with an individual bond are:
Who is issuing it?
What is the maturity date?
What is the coupon?
Bonds do differ. There are four main entities which issue 'true' bonds. Governments, supranational bodies, such as the European Investment Bank, local authorities and companies.
Government bonds have traditionally seen as the most secure and are used to benchmark the bond market. They are comfortably the biggest issuers and, assuming they borrow in their own currency, can in theory print more cash to pay the coupon.
A rough guide to credit quality is provided by ratings agencies like Standard and Poor's (S&P), Moody's and Fitch. S&P and Fitch both grade bonds in descending order. The S&P scale is probably the simplest running from AAA to AA+, AA, AA-, BBB+ and so on.
Bonds rated at BBB- or above qualify as investment grade. If a security slips below this threshold the price could collapse as the number of institutional investors sanctioned to buy non-investment grade or 'junk' bonds is more limited.
HOW TO INVEST IN BONDS
Minimum trade sizes on bonds can be upwards of £10,000 which in practice makes them relatively inaccessible to retail investors.
Many opt to invest in bond funds or exchange-traded funds instead - which also means you get exposure to a diversified basket of debt in a single trade. Popular examples include iShares UK Gilts (IGLT) and BlackRock Corporate Bond (B4QC331).
This is the latest in a series of guides on the basics of the financial markets to appear on our website in the coming weeks.
